Hello everyone, in this video we are going to learn about the equilibrium that comes from aggregate demand aggregate supply model which is similar to aggregate expenditure model. Basically when the production or the amount of output produced in the economy is exactly equal to amount of goods that are consumed or purchased in the economy that leads to equilibrium. That's what we show as economy's equilibrium. From the aggregate demand aggregate supply you economy point of view or model point of view.
To find this equilibrium, so on a given graph, let's say if you have real GDP on the horizontal axis and the price level on the vertical axis, if aggregate demand is like this and aggregate supply is like this, the point where these two are intersecting, that's the point represents economy's equilibrium. If you are at that point, two things we can figure it out. So one is equilibrium price level. which comes at on the horizontal axis. This is the price level equilibrium has.
And second thing is equilibrium real GDP that you can see it on the horizontal axis. That means economy will actually produce the real GDP equal to this particular equilibrium. Now we want to compare that to potential in the economy. So what happens is the potential real GDP may not necessarily equal to the... equilibrium real GDP.
Potential could be somewhere else. That means potential we show it with long run aggregate supply that could be something like this. If that means equilibrium is lower than the potential or the potential could be somewhere here.
That means equilibrium is higher than the potential. Either ways we have we actually leap to something called as GDP gap. So how to measure that one and how to get out of that that's what we want to see.
GDP gap simply means equilibrium real GDP is not equal to potential real GDP or long run aggregate supply. One could be inflationary gap. Inflationary gap means the economy is over producing. In other words equilibrium real GDP is actually greater than the potential GDP.
Whereas the other side is recessionary gap. The cause of recession comes in the recessionary gap here. So that means economy is actually producing less than the potential.
That's where we lead to recessionary gap. Now what we want to see is to get out of this gap there are policies which are fiscal and monetary policies but according to this model to get out of the gap sometimes economy can operate as self-correcting economy. That means no one has to take any action without any action from the government or any policy.
Economy eventually produce to the point that it will be equal to potential GDP that's what we call self-correcting. self-correcting economy. If it is a self-correcting economy, then what happens is we don't have to worry about taking care of the policies.
How does the economy self-correct? That's the question we ask. You want to see both sides. Suppose if economy is, let's say, in the recessionary gap. What we observe is not many people are able to find the job.
So that means there is less demand for the labor and we are under-utilizing the resources. Whenever we don't utilize the resources enough, that actually leads to decrease in the prices of the resources. When prices of resources decreases, aggregate supply starts to increase.
So if you have to present this one in terms of a graph, again consider real GDP here. Let's say aggregate demand and aggregate supply are here. Now consider the possibility of, right now equilibrium is somewhere here. If it is recessionary gap, what you can see is potential GDP in the economy is much bigger. That means potential is somewhere here.
That's what leads to recessionary gap in this case. This is the recessionary gap. Now, if demand for resources is low, that leads to prices of resources to decrease and aggregate supply starts to move to the right.
You can see, start showing it on the graph. You can actually see how it changes towards a potential GDP. That means if it will start moving like this, that's one increase and one more time increase.
If it continues to increase, eventually equilibrium comes here, which is same as the potential part. Okay. So that means if new equilibrium, equilibrium GDP will be equal to potential GDP.
As you can see, price level coming from the original point, price level starts to decrease. So simple thing. When you have recessionary gap, Things move in such a fashion, eventually prices has to drop.
Because that means, correctly speaking, that concept is deflation. Now, you can exactly imagine the opposite side. Suppose if it is an inflationary gap.
Inflationary gas means you're kind of overproducing more than the economy's potential. That means the demand for resources is more. When demand for resources is more, prices of resources will increase. When prices of resources increases, exactly opposite effect as the previous one.
Aggregate supply start to move towards the left. What happens? equilibrium real GDP will increase to the point that it's exactly sorry decrease to the point that it's exactly equal to potential GDP.
So easy way to draw a graph put aggregate demand like this aggregate supply like this initially here but potentially somewhat lower. So if prices of resources increases aggregate supply actually starts to increase decrease it decreases eventually it will come back to somewhere here. That's the case.
What do you see? Prices were here before and the prices will reach a little higher. That's what the name comes from.
Inflationary gap, in other words, it's actually leading towards the inflation. So what you see here is when economy is self-correcting, eventually price level in the economy is going to increase. Now, why do you need the policies like fiscal or monetary policy? Simple thing.
Self-correcting economy will take its own time. It can be a year, two years, or a decade. If that's the case, it can create a lot of damage in this particular process.
To minimize the damage, that's where we have the policies in place. Policies actually help to reduce the time period in terms of the time that it takes from the self-correcting economy. So to minimize the time of recession or to minimize the time of inflationary gap, the government takes the action or federal reserve takes the action in terms of implementing the policies.