But the two seem to me to be in conflict. I can't consistently believe both.

I like macroeconomics with monopolistic competition rather than perfect competition. It helps me make sense of the world. (Most modern macro models assume monopolistic competition.)

Let me start with three pictures of business cycles.

(They should be curvy rather than spiky, but I'm not good enough with Paint.)



The first picture is the one I normally draw when teaching intro macro. There's a reasonably smooth trend line for Real GDP (or some other measure of real economic activity). But actual RGDP fluctuates around that trend line. There are both booms (when it's above trend) and recessions (when it's below trend). It's symmetric. Some booms are big and some are small. Some recessions are big and some are small.



The second picture doesn't have any booms. It only has recessions. It's asymmetric. RGDP can be below trend, but it is never above trend. Some recessions are big and some are small.







The third picture (just for theoretical completeness) doesn't have any recessions. It only has booms. RGDP can be above trend, but cannot be below trend. It's asymmetric in the other direction. Some booms are big and some are small.

The first question you ought to ask is: "How can we tell the difference between those three pictures, if we don't actually see that trend line?"

If all booms and recessions were exactly the same size, we wouldn't be able to tell the difference. A trend line across the peaks (picture 3); a trend line across the troughs (picture 2) and a trend line through the midpoints between peaks and troughs (picture 1); would all fit the data equally well.

But if booms and recessions were all different sizes, we would be able to tell the difference. A trend line across the peaks works best in picture 2; a trend line across the troughs works best in picture 3; and a trend line through the midpoints works best in picture 1.

But there's a better way of telling the difference between those three pictures. It's what Milton Friedman used.

Imagine you started with a perfectly flat garden. In 1 you dig random sized holes, then use the soil you dug out to create random sized mounds. In 2 you dig random sized holes, and sell the soil you dug out. In 3 you buy some extra soil, and dump it in random sized mounds. If an ant were crawling across the surface of your garden, how could the ant tell the difference between 1, 2,and 3?

In 2, the ant would notice a strong correlation between how far he descended from peak to trough and how far he subsequently ascended from that trough to the next peak. But the ant would notice no correlation between how far he ascended from trough to peak and how far he subsequently descended from peak to trough. Big descents are always followed by big ascents, but big ascents aren't always followed by big descents.

In 3, the ant would notice a strong correlation between how far he ascended from trough to peak and how far he subsequently descended from that peak to the next trough. But no correlation between how far he descended from peak to trough and how far he subsequently ascended from trough to peak. Big ascents are always followed by big descents, but big descents aren't always followed by big ascents.

In 1, the ant would notice roughly the same weak correlation between descents and subsequent ascents as there is between ascents and subsequent descents.

Empirically, the business cycle in the real world looks closer to picture 2 than picture 1. More accurately, it's somewhere between pictures 2 and 1. Picture 3 doesn't work at all. (Which also means the more extreme Austrians, who say the seeds of the recession are always sown in the preceding boom, seem to be wrong.)

To use Milton Friedman's metaphor, it's like a string stretched tight along a board. You can pluck the string away from the board but it returns to the board when you let go and can't go past the board. Or to use Scott Sumner's metaphor, it's like valleys in a high plateau. What look like mountains are really just places where there is no valley. What look like booms are really just times when there is no recession.

Now look at the very simple macro model in picture 1m.







On average the economy is on the vertical LRAS curve. If there is a sudden unexpected fall in AD, the economy goes into recession to the left of the LRAS curve. If there is a sudden unexpected rise in AD, the economy goes into a boom to the right of the LRAS curve. Model 1m gives us picture 1. It's symmetric.







Now look at the very simple macro model in picture 2m. It works just the same as 1m if AD falls to produce a recession. But the SRAS curve either stops dead when it hits the LRAS curve, or else turns vertical when it hits the LRAS curve. So if there's a sudden unexpected rise in AD, there is no boom. Either prices fail to rise enough, and so there's excess demand for goods (when the SRAS curve stops dead), or else prices instantly rise so there's inflation but no excess demand or boom (when the SRAS curve turns vertical). It's asymmetric.

Perfect competition leads to a model like 2m. In long run equilibrium, when prices and wages have had long enough to adjust, firms and workers are selling as much output and labour as they want to at those prices and wages. You can't force them to sell more output and labour than they want to, even if demand does increase and prices or wages are sticky. You can't create a boom.

Monopolistic competition leads to a model like 1m. In long run equilibrium, when prices and wages have had long enough to adjust, firms and workers are not selling as much output and labour as they want to at those prices and wages. Because those prices and wages are above Marginal Costs. But individual firms (or workers) would have to cut prices (or wages) to sell more output (or labour), and they don't want to cut prices (or wages), because Marginal Revenue equals Marginal Cost. But if aggregate Demand increased, and if prices or wages were sticky, firms and workers would sell more output and labour. So we get a boom.

So how do I reconcile monopolistic competition and the plucking model?

Perhaps this is the answer: if monopolistically competitive firms are hit with a small positive demand shock, and their prices are sticky, they will increase output to satisfy demand. But if monopolistically competitive firms are hit with a large positive demand shock, and their prices are sticky, they will not increase output to satisfy demand, because doing so means they would go past the point at which price equals marginal cost. Small booms are possible, but large booms are impossible. But both small and large recessions are possible. The model is a hybrid of 1m and 2m. The SRAS curve continues a small way to the right of the LRAS curve, but then stops dead. And the outcome would also look like a hybrid of pictures 1 and 2.