Inflation, Supply-Shocks and Why EclectEcon Should be Teaching my GEOB 405 Class

We spent the first 9 classes (of a 20 class course) studying the classic AD-SRAS-LRAS framework. One topic that came up repeatedly was how to model the current economic situation using that model. Eclectecon describes the current situation in far fewer words than I could:

t seems pretty clear to me that if aggregate demand is pushed upward, then in the short run the economy will experience reduced unemployment rates and (often with a lag) higher rates of inflation. During such a period, the unemployment rate drops below the natural unemployment rate (or the NAIRU), and that seems pretty much like what the North American economies were experiencing during the past few years. We had unemployment rates lower than we had seen for the past 25-30 years. These numbers make it seem that our economies had been pumped up by the spending supported with loose credit conditions.

We learned in the late 70s and 80s that we cannot sustain these low unemployment rates by continuing to inflate aggregate demand. Eventually the unemployment rates rise back toward their natural rates. This process of having our unemployment rates rise as we slide along the short-run Phillips Curve is not the same thing as an inadequate-aggregate-demand-induced recession; rather, it is a reversion to long-run equilibrium. Furthermore, any attempts to head off this reversion to the long-run are likely to be highly inflationary. Both the Fed and the Bank of Canada will have to be very careful not to over-inflate our economies in a futile attempt to reduce or hold unemployment below the natural rates.

I have been convinced for some time that treating the current situation as a demand-side problem is terribly misguided. Between the liquidity crisis and rising prices for commodities such as oil, copper, etc. there are a great deal of stresses on the supply side. Treating a supply-side shock as a problem with demand is a recipe for causing an inflationary spiral.