in this video we want to talk about a model that we call the aggregate demand aggregate supply model and i'll say this several times throughout this video this model works mechanically a lot like a plain old demand supply model but it is very different from a plane demand and supply model what we're going to be thinking about is aggregate demand so in the stuff that we did at the beginning of the semester when we were talking about demand and supply we were thinking about demand for a single good and supply for a single good with the aggregate demand model we're going to be thinking about demand for everything in the economy all at once and the supply of everything in the economy all at once now the nice thing about this model is this model allows us to kind of understand what causes economic fluctuations and so we'll be able to understand the things that can lead to a recession and we'll be able to use this model to think about the things that we can do to try to get out of a recession we'll be able to understand what leads to expansions and so this will be a very useful model for figuring out why economies fluctuate from one time period to the next we need to start by thinking about some key facts key things that we know about economic fluctuations so the first thing that we know about economic fluctuations is that they are irregular and unpredictable irregular and unpredictable there will be you will if you pay attention you will run into many people who will try to convince you that they know when the next recession or when the next expansion is coming often times those people will be trying to sell you a book or sell you an investment or sell you something else information and they may be very convincing in trying to convince you that they they know what they're talking about but one thing that we know from from history is that the business cycle is irregular and unpredictable now it's unfortunate that economists call the business cycle the business cycle because that word cycle implies that there's some regular pattern and so if you were to look at in mathematics if you were to look at a sine wave a function of the sine function or the cosine function it's a regular and predictable pattern in terms of the business cycle it is not regular or predictable so that's the first thing that we know another thing that we know is that most macro variables fluctuate together most macroeconomic variables fluctuate together now let's talk about what that means that doesn't mean that they all move in the same direction or by the same amount but when things start to move typically lots of stuff starts to move we start to see incomes changing and at the same time we see firm profits changing let's suppose we go into a recession and so incomes are going to be going down and firm profits are going to be going down and foreclosures will be going up and unemployment starts to go up and the price level starts to move and interest rates start to move so we start to see lots of stuff move together and again not all of them move in the same direction and they don't all move in the same amounts and so um that doesn't mean that as soon as you see one thing move you know what's going to happen to the other things it's it's challenging but we know that things tend to move together and then another key thing that we know is that as output falls unemployment rises as output falls unemployment rises remember that we use output gdp to measure incomes so we can think about this in terms of incomes output is how we measure income as income falls unemployment rises okay so those are kind of three key things that we know historically about economic fluctuations now let's talk about how we're going to use this model this model is actually what we would call a short run model all of the things that we've talked to or talked about in this class up to this point we've talked about in the long run so those models where we were thinking about the demand and supply for loanable funds or the the things that caused unemployment to go up or down all of those things were monetary neutral neutrality all of those things were long run models this aggregate demand aggregate supply model is a short run model and this helps us understand what causes short run fluctuations in an economy it can be very useful so our model focuses on the relationship between two things so let's say it this way this model focuses on the relationship between the price level and real gdp focuses on the relationship between those two things now let's think about that for a second because if you think back to when we talked about monetary neutrality we talked about the fact that you can divide different economic variables into two groups those that we call nominal and those that we call real and what we saw is that changes in the money supply have impacts on nominal variables but not real variables in other words inflation doesn't matter but what that is is a long run model inflation doesn't matter in the long run if the fed adjusts the money supply then that changes the price level but if all prices change it doesn't really matter well this model is a short run model in the long run there would be no relationship between the price level which is a nominal variable and real gdp which is a real variable in the long run those are different types of variables that are not related to each other but in the short run they can be and so that's the key thing that's new about what we're going to do in this chapter now let's think about what this aggregate demand aggregate supply model looks like because it's going to look very familiar to you it's going to work very different so in terms of what the aggregate demand aggregate supply model looks like here's what we do we put the price level up here sometimes i'll just call it p at least at the beginning of when we start working with this i'll try to write the price level because i don't want you to think that if i write p up there that it's just the price of one good this is the average level of prices in the economy and then down here we're going to put real gdp this is let's write it first real gdp this is y like y equals c plus i plus g plus net exports real gdp now once we get comfortable with this i'm just going to switch to calling it p and y but i want you to remember that this is the total amount of goods and services bought and sold in the economy and this is the average level of all of those prices in the economy now our aggregate demand curve is going to be downward sloping i'll typically abbreviate it a d and our aggregate supply curve is going to be upward sloping for right now i'm going to label it as we'll see that there are actually two different aggregate supply curves but for right now let's just talk about that so in terms of how this looks this looks like a any other demand supply model that we've talked about our equilibrium is going to be found right there at the intersection and so i'll call this p star that's going to be the equilibrium price level in this economy and this will be y star this will be the equilibrium level of real gdp in the economy so the intersection gives us the equilibrium but now let's think about what each of these curves shows this aggregate demand curve shows the total quantity of goods and services bought or demanded in the economy at each price level and we can see that at higher price levels overall demand in the economy is lower than it is at lower price levels at low price levels people want to buy more stuff and we'll talk about why here in a second our aggregate supply curve represents the total amount of goods and services that firms want to sell at each price level at low price levels firms want to sell a relatively small amount of goods and services and at higher price levels they want to sell a relatively high amount and we'll talk about why that's true here in just a little bit but this is very different from a regular demand and supply curve so let's think about what a regular demand curve looks like so there if this was a regular demand curve we would just have the price of whatever this good is and we would have the quantity of that good and what this tells us is that at a price like p1 the quantity demanded is high q1 and at higher prices quantity demanded falls at a price like p2 quantity demanded falls to q2 and let's think about why that happens we talked about that earlier on in the semester as prices rise two things happen there's an income effect and a substitution effect the income effect says that as the price of something you buy goes up that has a negative impact on your income and you tend to buy less because of that the substitution effect says as the price of something you buy goes up other things become cheaper in comparison and you substitute towards those other things so for a regular demand curve it's downward sloping because of the income and substitution effects that's not happening in this picture and the reason is this demand curve represents demand for all goods and services every good is represented along that demand curve so there's nothing else to substitute towards so it slopes downward for a very different reason than a regular demand curve slopes downward and the same with a supply curve when we're talking about just a regular supply curve for one good that's very different from the aggregate supply curve that represents how much goods and services all firms want to sell of all goods and services depending upon the price level so keep that in mind as we go through here let's start by thinking about aggregate demand we want to think about why the aggregate demand curve slopes down in other words why is it that when the price level changes people want to buy more stuff or less stuff and then we need to think about what causes the aggregate demand curve to shift around so the key to understanding aggregate demand is to remember this y equals c plus i plus g plus net exports so gdp this is the national income identity gdp any dollar that's in gdp is either going to be consumption or investment or government spending or net exports this one g is determined by government policy so let's just say that one has to do with government policy the government chooses that one so we don't need to worry about that one right now what we want to know is how does the price level affect consumption investment and net exports why does the price level change the amount of goods and services that people want to consume why would the price level change the number of dollars that firms want to invest remember investment is when firms buy buildings and equipment to make more output in the future why is it that the price level would change our net exports which is exports minus imports so let's start by thinking about consumption so when we think about consumption the key thing that we're going to talk about here is what we call the wealth effect so here's what the wealth effect says the wealth effect says that when when prices fall dollars are more valuable when prices go down your dollar buys more and so consumers feel wealthier and as a consequence they buy more stuff okay so a decrease in the price level will lead to an increase in consumption because of the wealth effect now let's keep in mind this is a short run model in the long run consumers would really realize that if all prices change then it's not just the prices of what they buy that's gone down but the price of their labor has also gone down but we're talking about the short run right now okay so a decrease in the price level will increase consumption and that means that because consumption is a part of real gdp a decrease in the price level causes more goods and services in total to be demanded let's talk about now investment and this is something that we're going to call the interest rate effect so let's think about how this works so when prices fall people need to hold less money to engage in transactions and when you need to hold less money you lend your money out well that lending of your money out decreases the interest rate and when the interest rate goes down investment goes up when the interest rate goes down it costs firms less to borrow to invest and so in this case a decrease in the price level will lead to an increase oops lead to an increase in investment a decrease in the price level causes that one to go up as well and then finally let's talk about net exports and we'll talk about the net export effect so with the net export effect when prices fall we just talked about the fact that interest rates are going to go down because people need to hold less money and they lend it out well if interest rates go down then people who are looking to save money by buying assets are going to look outside the country because interest rates in this country are going to be going down so savers will be buying assets denominated in foreign dollars and we could talk about how that causes the exchange rate to change but let's just say that that causes the dollar to get weaker compared to other currencies and when that happens when foreigners dollars get stronger compared to ours or foreigners currencies get stronger compared to ours that stimulates our exports so a decrease in the price level causes an increase in net exports when our dollar gets weaker we buy less from other countries and other countries buy more from us and net exports goes up so all three of these things when the price level goes down it causes consumption to go up it causes investment to go up it causes net exports to go up so a decrease in the price level will lead to an increase in the amount of stuff that firms and households and other countries want to buy from us so that helps you understand hopefully why the aggregate demand curve slopes downward now what we want to do is talk about why the aggregate demand curve might shift so what we need to do now is focus on something other than the price level because we've got the price level here then changes in the price level will move us to a new point on this aggregate demand curve but if we talk about something other than the price level changing then that aggregate demand curve will shift so let's talk about shifts in aggregate demand and the best way to think about shifts in aggregate demand again is to think about shifts that have to do with consumption investment government spending net exports anytime you're thinking about aggregate demand remember this at this national income identity that'll help you try to remember all of the things that can cause the aggregate demand curve to shift so let's think about shifts from consumption so what are the things that can cause consumptions consumptions to change so anything that causes people to um be pessimistic or optimistic about the future it's easier to think about people becoming pessimistic so when people become pessimistic about the future they quit spending their money so anything like a terrorist attack or anything like a virus that that causes people to be scared to go out or something like a rule that says you can't go out and spend your money you've got to stay in your house clearly is going to decrease consumption so we could think about pessimism that can be caused by a war or a virus right or it could be some scandal in the white house or any of a thousand other things a terrorist attack let's put that could be a stock market crash or there's a infinite number of things that can cause people to become pessimistic or optimistic about the future when optimism takes over people are more confident and they go out and they think about buying a car or they think about replacing a dishwasher or they think about spending their money we can also have shifts that come about from investment this is very similar to consumption except now with investment we're talking about firms so if we think about say new computer technology so if some new let's say faster processors are invented that would increase productivity then firms will start to invest in that but it can also be things like this a virus right so or the government just telling you that you you can't operate your business well if you can't operate your business your business is not going to be buying buildings or equipment so firms becoming pessimistic about the future that will cause a shift in aggregate demand it will change the amount of investment that firms engage in we can think about let's say tax incentives so if the government increases taxes say income taxes for consumers or for firms that leaves fewer dollars for for consumers or firms to spend and so an increase in taxes is going to decrease aggregate demand or a decrease in taxes would increase it we can also think about the money supply now this one i'm not going to talk about misspelled supply not going to talk about right now because we're going to spend our next chapter thinking about a lot about that one so i'm just going to kind of sneak it in right here and then we'll come back to that one later we can also and and tax incentives this applies to both investment and consumption let's go to government spending clearly the government can decide to spend money on roads or whatever they want to spend money on and an increase in g will cause the aggregate demand curve to shift to the right a decrease in g will cause the aggregate demand curve to shift to the left so the government could spend their money on buildings or new fighter jets or any of a million things that the government spends money on then we could have shifts from net exports so this could come about because there's a recession in europe if there's a recession in europe and incomes in europe are falling then they're going to be buying less stuff from us and that will decrease our net exports so anything that happens in another country a virus in other countries will cause those other countries to buy less from us and that impacts us so all of these things you can have shifts in aggregate demand that come from consumption shifts from investment shifts from government spending shifts from net exports i'm sneaking in money supply right there we'll come back to that so now we know why the aggregate demand curve slopes downward that's this stuff now we know what causes aggregate demand to shift that's that stuff right there what we need to do now is think about aggregate supply so i'll clear this off and we'll take a look at that i mentioned at the beginning of this that there are actually two aggregate supply curves we're going to start with the simple one actually both of them are pretty simple but we'll start with the most straightforward one first and that is the long run aggregate supply curve so let's take a quick look at what that's going to look like we've got our price level up here which is p we've got real gdp down here which is y our aggregate supply in the long run is going to be vertical and i'm going to denote it long run aggregate supply what this means is anytime you've got one that's vertical what this means is that the price level doesn't have any impact on our long-run aggregate supply in other words if the price level is low here's what long-run aggregate supply is or if the price level is high here's what long run aggregate supply is okay this really reflects that monetary neutrality that we talked about in an earlier video the short run aggregate supply is going to be upward sloping but let's focus on this one right now so in the long run in the long run gdp is determined by things like factor supplies inputs that we've got resources that we've got technology that we've got in the long run now in the short run it can be determined by other things but in the long run real gdp is determined by things like technology inputs all right how many workers we've got how many raw materials we've got it's determined by technology inputs let's just say um workers let's add that as a separate one because we'll break that out here in a second we've got a name actually for this point where the long run aggregate supply curve is vertical and we call that the natural rate of output natural rate of output that's the amount of stuff that we produce in the economy when the unemployment rate is at its natural rate remember the natural rate of unemployment is not zero there's always some unemployment in the economy but that's our natural rate of output so the amount of stuff that we can produce when the economy is operating at its natural rate of output sometimes we call that full employment output the amount of output that we can produce there is going to be determined by things like technology inputs workers that kinds of those kinds of things not the price level so let's think about what causes the what causes long-run aggregate supply to shift so we can have shifts from labor that's an important thing if we have more workers immigration then that will shift our long-run aggregate supply to the right or if we had an increase in the minimum wage so let's suppose we have increase in minimum wage remember that an increase in the minimum wage results in unemployment that results in less people working that decreases our long-run aggregate supply to the left we could have changes in unemployment policy so anything that that makes being unemployed less painful will result in people being unemployed for longer periods of time and shift long run aggregate supply to the left we can have shifts from capital and this can be human or physical capital so anything that increases the amount of capital let's say an increase in the capital stock will result in an increase in long run aggregate supply it allows us to produce more goods and services in the economy we can have shifts from natural resources so if all of a sudden um some new natural resources are discovered in the country then that will increase the amount of goods and services that we can produce we can have shifts from technology if we have a technology improvement that can allow us to use the same natural resources and the same capital and the same labor but be able to make more output so all of those things can cause our long-run aggregate supply to increase now with what we've got here we've got aggregate demand and now we've talked about aggregate supply that allows us to help understand why we tend to observe changes in output and changes in the price level in the long run so let's take a look at using this simple model to to think about the effect of long run growth in the economy and inflation so let's draw a quick picture and put together the aggregate demand curve that we've got and that long run aggregate supply up here we've got our price level and down here we've got real gdp so this is p this is y let's put our aggregate demand here i'm going to call that aggregate demand curve one and we'll call this long run aggregate supply one our intersection is right here so here's our initial price level and our initial level of real gdp so if we think about an economy over time we can think about what happens to both aggregate demand and aggregate supply over time and what we tend to see over time is that the aggregate demand curve shifts to the right and we tend to see long-run aggregate supply shift to the right one of the bit main increases of aggregate demand tends to be monetary policy remember we talked about the fact that the money supply increases aggregate demand so if from time period one to a time period in the future we get an increase in aggregate demand to aggregate demand two and we get an increase in long-run aggregate supply to long-run aggregate supply 2 then what we will observe over time is increases in real gdp increases in incomes real incomes and inflation and that's what we tend to see in the united states especially over time we tend to see that incomes real incomes have risen and we tend to see inflation in the economy and the sources of those things at least we can use this model to help understand the sources would be monetary policy that shifts aggregate demand and changes in technology that shifts long run aggregate supply what we need to do now is we need to take a look at short-run aggregate supply and then we'll be able to see what happens what causes short-run fluctuations in the economy so i'll clear this off and then we'll do that so we've talked about the aggregate demand curve and we've talked about the long run aggregate supply curve what we want to do now is think about the short run aggregate supply curve and it turns out that the short run aggregate supply curve slopes upward and so let's just take a quick look at what it looks like so remember we've got our our price level up here we've got the real level of gdp down here our short run aggregate supply is going to look like this it's going to be upward sloping what this means is that at low price levels there's a small quantity of goods and services available that all of the firms in the economy want to sell and then at high price levels all firms are going to want to sell more so we've got to think about is why would a change in the price level cause firms to want to sell more or less and so there are some ideas that economists have come up with to try to explain why this relationship might hold in the short run and let me remind you something i've i've reminded you of throughout this chapter this is a short run model in the long run there wouldn't be any relationship between the two and of course that's what the long run aggregate supply curve shows that's why the long run aggregate supply curve is vertical because changes in the price level don't influence that natural rate of output there are three potential explanations that economists have come up with that might explain this relationship the first is what we're going to call the sticky wage theory and the idea here is that nominal wages are slow to adjust or essentially they're sticky okay so what this means is that if the price level rises while nominal wages are stuck and those nominal wages might be stuck because of labor contracts so maybe you agree to work at a particular job over the next year for a particular wage that nominal wage let's say they're going to pay you a certain number of dollars per hour or if you work for a salary you're going to be working for you're going to sign a contract that says i'm going to work for x number of dollars for the next year and then at the end of that year you can renegotiate that contract but during the period of time that that contract applies your nominal wage is going to be stuck so if the price level rises while nominal wages are stuck then for those firms that are paying the wage the real wage that they have to pay actually goes down so if the price level rises then firms are able to sell their output for for more than they used to but their input costs are not going up because the wages that they have to pay are sticky and that benefits the firms and so as the price level goes up their real wages that they have to pay are falling and consequently they sell more so they increase production of goods and services at higher price levels they would decrease production of goods and services at lower price levels you can just reverse that argument that i just made and that would tell you why at low price levels they want to sell a smaller quantity so that's the sticky wage theory and it's just one of three possible explanations that we're going to think about the second one that we're going to think about is sticky price theory and the idea here is that the prices of some goods and services are slow to adjust so when economic conditions change maybe it's because of something like menu costs for firms maybe it's costly for them to change their prices frequently so they don't change them frequently and so when the price level changes some some prices in the economy are just kind of sticky for a while so what happens here is that because some prices are sticky when the price level goes up for for the firms whose prices are sticky that leaves them with relatively lower prices than the other firms out there in the economy and because of that because they have relatively low prices that stimulate sales for those firms and they consequently sell more so clearly not a long run situation because in the long run they would be changing their prices but in the short run that one i guess that that could happen um and then the third one is what we call misperceptions theory the idea behind the misperceptions theory is that a change in the price level causes firms to misperceive what's going on so they perceive that change in price level as a change in just their relative prices they don't realize that all prices in the economy are going to be changing so essentially they mistake a change in the overall price level for a change in their relative price so when the price goes up they don't realize it's inflation they think that it's maybe increased demand for their product that's driving the price of their product up and so they sell more so if we think about these if you were to ask me personally what i think about them i find the sticky wage theory to be somewhat reasonable i think that there there are wages that that are sticky over certain periods of time and maybe that leads to to what we're seeing here and there it seems reasonable to me that there can be some sticky prices out there in the economy sticky output prices this one has to do with input prices being sticky the idea here is that output prices may be sticky as well and and maybe they are misperceptions theory honestly i personally i don't find that one to be very convincing i think businesses aren't going to make this mistake for very long at all and if they if you're a business person and you're you tend to make that kind of mistake probably not going to be a business person for very long now the idea here is that it could be some combination of all three of these these aren't explanations that rule out each other and so maybe it's that's at different periods of time and maybe to different extents maybe all three of these are explanations for what we see here in terms of the upward sloping short run aggregate supply curve so the idea here is that all of them tell us that the real amount of output that gets produced is going to be different when or it's going to be affected when the price level is something other than what firms expect if they if they get surprised by the price level then there's going to be a change in this amount of output that they produce and we can actually identify a kind of a mathematical equation that will help us hopefully understand this so the amount of output supplied let's say the quantity of output supplied is going to be equal to the natural rate of output plus a multiplied by a couple of things it's going to be the difference inside these parentheses is going to be the difference between the actual price level and the expected price level so let's think about what this means if firms are right in terms of what they expect about the price level if the actual price level turns out to be exactly what they expect then the actual price level minus the expected price level this term is going to be zero and this whole term will cancel out over here it'll be a times zero that term just falls out and in that period of time the quantity of output supplied is just the natural rate of output but if firms are surprised by the amount of output if the actual price excuse me surprised by the price level that exists in a particular time period if the actual price level turns out to be something different from what they expect then this term will not be zero we will multiply it by a and then the amount of output that particular time period will be the natural rate plus or minus some term over here the the magnitude of a determines how big the surprise in price level how big of an impact that has on the quantity of output okay so if the actual price level turns out to be something higher than what they expect so if if there's unexpected inflation then the actual price level minus the express expected price level would be a positive number multiplied by a we would add that to the natural rate of output remember that the long run aggregate supply curve is vertical at the natural rate of output here's the natural rate so as long as we're not as firms are not surprised by the price level then the natural rate is just the natural rate and we the price level would have no impact but if the price level turns out to be higher than what firms expect then we're going to have a higher quantity of output than the natural rate or if the price level the actual price level turns out to be lower than what firms expect then this term would be negative and then it would be the natural rate of output minus some amount here's the natural rate of output minus some amount it would be back here and so this formula here kind of helps you understand why the natural rate of out or why the amount of output supplied in a particular period would be higher when the price level ends up being higher than what they expect and why the amount of output would be lower when the price level is lower than what firms would expect now in terms of how you use this this is really just to help you understand what's going on in that picture this isn't something that on a test i would give you whatever three out of the four things and ask you to solve for the fourth there's no reason i couldn't but it's not something that i typically put on a test so hopefully that gives you an idea of what's going on with the short run aggregate supply curve let's talk about um things that shift short run aggregate supply things that shift short run aggregate supply and this is actually pretty easy because the same things that shift the long run aggregate supply curve also shift the short run aggregate supply curve so let's say all of the things that shift long run aggregate supply also shift short run aggregate supply so let's just briefly review those we talked about the long-run aggregate supply curve shifting if something about the amount of labor that we've got changed so we can get changes from labor so if there's immigration into the u.s then that means there are more workers that will shift the long-run aggregate supply curve and the short-run aggregate supply curve to the right it is not the case that when somebody comes into the country and finds a job that that means that there's one less job for other people to take that's not the way the world works we talked in a previous video about the idea that oftentimes people think that the world is a zero-sum game it is not the case that there is a fixed number of jobs out there and if one person takes a job that's a job that can't be had by another person when those aggregate supply curves shift to the right we'll talk about what happens here in a little bit that increases the amount of goods and services that we can produce and so we can have changes from labor we also talked about changes from capital so when the capital stock increases more equipment more buildings when the capital stock increases that increases the that shifts the short-run aggregate supply curve to the right and it shifts longer in aggregate supply we talked about changes from natural resources we talked about changes from technology all of those things will shift both the aggregate supply curves to the right but now there's a new thing that shifts the short run aggregate supply curve that does not shift the long run aggregate supply curve so let's say uh but there's a new thing and that thing is the expected price level expected price level when firms change their expectations about the price level that will shift that short-run aggregate supply curve to the right now that does not shift the long-run aggregate supply curve we didn't talk about that when we were thinking about long-run aggregate supply and the idea there is that long-run aggregate supply has to do with these things real things short-run aggregate supply has to do with some real things but also a nominal thing a monetary thing okay in the expected price level the expected amount of inflation or deflation that we're going to experience so here's the idea here's the logic behind this if let's say there's an increase in the expected price level increase in the expected price level let's think about how firms will will think about that increasing the expected price level that's going to lead to firms expecting to have to pay more for inputs in the future firms expect to pay more for inputs oops firms expect to pay more for inputs and when input prices go up that means firms are going to decrease the amount the quantity supplied of goods and services so this is going to lead to a decrease in quantity supplied of goods and services and anytime there's a decrease in the quantity supplied of goods and services short-run aggregate supply shifts to the left let's say decreases shorten aggregate supply decreases so if firms expect a higher price level then if we're looking at a short run aggregate supply curve and it's sitting right there short run aggregate supply we'll call it short run aggregate supply one here's the price level here's real gdp if firms expect the price level to be higher in the future that's going to shift this short-run aggregate supply curve to the left if firms expect a lower price level in the future that would shift the short-run aggregate supply curve to the right okay changes in the expected price level don't have any impact on the long-run aggregate supply it's just the short run aggregate supply so now let's just kind of recap what we've done we talked about the aggregate demand curve we talked about why it slopes downward remember the key to remembering those explanations is to remember that national income identity y equals c plus i plus g plus net exports so we talked about why it slopes down and we talked about what causes it to shift around and it all of those explanations had to do with those things and then we talked about the long run aggregate supply what what determines the amount of output we can produce in the long run and that has to do with the amount of real inputs and the technology that we've got labor and capital and natural resources technology and now we've talked about the short-run aggregate supply and we've seen that in the short run firms can make mistakes about the price level or it could be that wages are stickier it could be that output prices are sticky and so when the price level changes firms react to that they aren't fooled by that in the long run and they don't make those mistakes in the long run but in the short run they can and so we talked about the short-run aggregate supply curve and why it slopes upward and then what causes it to shift all of these same things as the long-run aggregate supply but now the expected price level is something that's really important firms expect a higher price level in the future that shifts short-run aggregate supply to the left they expect a lower price level that shifts it to the right so now what we can do is we can take these three curves and we can start to use them to understand what happens in an economy when when things change okay so we're going to be thinking about two causes of economic fluctuations two causes of economic fluctuations and the two things that we're going to think about are going to be shifts in aggregate demand and shifts in aggregate supply i'm not going to distinguish right there between short run and log long run aggregate supply but what we want to do is we want to think about figuring out what long run equilibrium looks like in this particular model so let's think about what we mean by long-run equilibrium so to be in long-run equilibrium means that we are also in short run equilibrium remember we talked about the idea behind an equilibrium when we were thinking about the basic demand and supply model an equilibrium is a a a situation of rest where things won't change unless something outside of the model changes so let me show you what long run equilibrium looks like in this aggregate demand aggregate supply model so if we think about we've got price level up here real gdp down here we've got an aggregate demand curve that's downward sloping it looks like this we've got a long run aggregate supply curve that's vertical it looks like this long run aggregate supply it is vertical at the natural rate of output and then we've got a short run aggregate supply now i'm going to draw my short run aggregate supply curve right up through that intersection of my long run aggregate supply and my aggregate demand there's short run aggregate supply all three of those are intersecting at the same place and just like the basic demand and supply model the intersection of those gives us the equilibrium so the coordinates of this point tell us the price level we'll call it p1 and the level of income in the economy why one that's the level of gdp so let's talk about being in short run and long run equilibrium let's start with the short run well if we're interested in what the short run equilibrium looks like we need to look at the intersection between the aggregate demand curve and the short run aggregate supply curve and that intersection happens right there if we want to think about long run equilibrium then we want to look at the intersection between the aggregate demand curve and the long run aggregate supply curve and we see that that intersection also takes place right there so we are in both short run and long run equilibrium now we can be in a short run equilibrium and not be in long run equilibrium but we cannot be in long run equilibrium without at the same time being in short run equilibrium what that means is in the short run something that can happen to push us to a short run equilibrium but then over time we will move to a long run equilibrium okay so it's important that you understand where we start i'm typically going to label our starting point point a we're always any time we use this model we're going to start with a picture of long run equilibrium and then we're going to shift one of these curves and we're going to move to a short run equilibrium and then we'll think about what happens as we move to a long run equilibrium so what i want to do is clear this off and then we'll work through a couple of examples of shifts in aggregate demand and shifts in aggregate supply let's take a look at what happens when aggregate demand shifts now what i want you to do is you're taking notes here is draw another picture of that long run equilibrium so that we can work through it and you don't mess up in your notes what that picture looks like because you need to know where we start there so i'm going to draw it again let's start with price level real gdp aggregate demand i'm going to put my long run aggregate supply curve and my short run aggregate supply curve right up through there i'm gonna label my initial intersection there point a i'm going to call my initial price level p1 and my initial level of real gdp y1 so now let's think about putting a story together here so we're going to start at a price level is equal to p1 real gdp i'm going to say y is equal to y1 now remember that real gdp is income so this is essentially the income of the of everyone in the economy right there now what's not shown on this picture is unemployment and other things but we'll talk about how those things change when the real level of gdp changes so we're starting at a let's suppose that something happens that causes aggregate demand to decrease suppose there's a decrease in aggregate demand now let's just review the things that cause that a decrease in aggregate demand can be caused by um people being pessimistic it can be caused by a terrorist attack it can be caused by a war it can be caused by a virus coveted 19 can cause people to be pessimistic not go out into the economy and spend money and especially when the government is forcing people not to go out they're being prevented from going out and spending money so that can cause a big decrease in aggregate demand and so that's exactly part of the explanation for what we've seen with the the impact of the lockdown with the pandemic so we've got aggregate demand let's shift that aggregate demand curve to the left and move it from aggregate demand 1 to aggregate demand 2. so we get a decrease in aggregate demand let's say 2 aggregate demand 2. now we need to think first about what happens in the short run and then we're going to think about what happens in the long run so let's start with the short run in order to figure out the place that this economy is going to go in the short run we need to look at the aggregate demand curve and the short run aggregate supply curve right here will be where this economy will go in the short run i'm going to call that new intersection point b and the coordinates of that point b are going to give us the new price level which is going to be p2 is going to give us the new level of real gdp which will be y2 so what we see is we get a new equilibrium at b the price level falls to p2 and real gdp falls to y2 so real gdp incomes falls to y2 the economy is in a recession what we've had is a decrease in the price level we've had a decrease in incomes and the bigger that shift in aggregate demand the bigger the decrease in real gdp now let's think about what's going on behind the scenes so less goods and services are being bought and sold and what that means is that firms are selling less goods and services which means they need fewer workers and so in the background not shown on this picture but we know something that happens when real gdp goes down is unemployment goes up so there's also going to be increases in unemployment while this happens there's going to be increases in the number of people who can't pay their debts so banks will start to foreclose on on um house loans that and car loans that people have stopped paying off because maybe they don't have a have a job to earn money to do it so other bad things decreases in profits for firms increases in foreclosures as i said so here at point b we're in a recession now let's think about the long run so notice that one of the things that's happened is that the price level has gone down so firms will expect a lower price level in the future let's let's think about all of the different possibilities that could happen here once we're at this recession point this point b the first thing is we can think about whether government should do something so let's let's ask this question what should government do well there are a couple of things that the government could do we talked about the fact that a change in government spending g or a change in the money supply will also shift aggregate demand so one possibility is for the government to increase government spending and shift the aggregate demand curve back where it came from now that clearly won't work in the case of a pandemic where the government does not want people going back out into the economy to spend dollars and so if let's suppose that this was a recession that was caused by say a terrorist attack and people get pessimistic about the future but there's no reason that those people can't interact out there in restaurants and stores and and things like that in that case we might say well if if aggregate demand shifts to the left because of this wave of consumer pessimism that that came about because of the terrorist attack then let's increase g so one possibility is to increase g and or increase the money supply let's write that out increase money supply both of those things have the effect of shifting aggregate demand to the right so if the government were to act quickly and decisively they could theoretically shift the aggregate demand curve back where it came from and move us back from point b to point a that's a possibility what we tend to see is that as a practical matter the government typically can't react quick enough by design that there are are checks and balances built into the political system that prevent the government oftentimes from moving rapidly enough to actually achieve what they want to achieve but there's no reason theoretically that they couldn't think about doing that and and we tend to see these things happen the government tends to do these things during periods of recession so that's a possibility there's a lot of dispute amongst economists as to whether or not the government is actually successful when it tries to do this but there's another thing that could happen even if the government doesn't do anything let's say even if the government does nothing the recession will eventually end and here's why let's say we'll eventually end we don't know how long this will take here's why notice that the price level is below what firms expected so firms will adjust their expectations about the price level now if you think back a few minutes you'll remember that one of the things that shifts the short run aggregate supply curve is firms expectations about the price level in the future so if firms expect a lower price level in the future then that shifts short run aggregate supply curve to the right so the price level has fallen this means that firms expect lower prices in the future firms expect lower prices in the future and let's just say here that remember that the impact of that when they adjust their expectations about the price level is that we're going to have an increase in short-run aggregate supply when firms expect lower prices in the future they're going to expect to be able to pay less for inputs in the future that shift short run aggregate supply curve to the right remember that's not going to change the long run aggregate supply curve but what happens is as that short run aggregate supply curve shifts as firms adjust their expectations it's going to shift until we get to a new long run equilibrium right down here at point c so we get a rightward shift of the short-run aggregate supply curve from short-run aggregate supply 1 to short-run aggregate supply 2. we get a new long-run equilibrium right back here at point c notice that that occurs at a lower price level of p3 and also notice that what's happened is that real incomes have gone down in the short run but then they went back in the long run as firms adjusted their expectations about the price level so we go into a res we start at point a not in a recession we move to a recession at point b even if we do nothing eventually what will happen is through firms adjusting their expectations of the price level we move to a new long run equilibrium there at point c incomes are back where they started the price level is lower than where it started so we get a new equilibrium at c price falls to p3 let's say price level falls to p3 income or real gdp real gdp is back to y1 it went down to y2 in the short run came back to y1 in the long run if we were to look at say a picture of what the price level looks like in the short run so let's put uh time on our horizontal axis let's put the price level up here price level this is p we could also think about what happens to income so let's put y up here this is real gdp or income let's write both of those real gdp income also put time on the horizontal axis let's put here p1 and y1 and so when we start out at our initial equilibrium at point a then what's happening as we let's suppose we're just sitting at that long run equilibrium then if we looked at what the price level looked like over time it would be sitting there at p1 and our real income would be sitting there at y1 and then all of a sudden the aggregate demand curve shifts now remember that the aggregate demand curve shifted here because we thought about a terrorist attack or maybe it's this pandemic where the government says you can't go out and spend things let's go with the terrorist attack though what typically happens with a terrorist attack is that people fear that things will be bad in the future and notice what happens with that the fear is self-fulfilling fearing a recession creates the recession that's why a lot of economists have very mixed feelings with how the media talks about recessions the more the media talks about how bad the recession is and how long it's lasted the more we would expect it to be bad and last longer so the best thing to one of the best things to to help with that is to try to to be optimistic about what the future looks like i don't know exactly what that means in terms of whether or not you can have public policy around that i mean that that's very very challenging you can't it's hard to be optimistic when things are bad so but the idea here is that pessimism fear of a bad outcome at least with an economy like this will create the bad outcome so what we saw was that when that aggregate demand curve shifted we saw the price level fall and we saw real gdp fall not necessarily by the same amounts here and then we move to that equilibrium there at point b and we're sitting at that equilibrium so maybe the price level kind of levels out and real gdp levels out there for a while and then over time either if the government were to shift aggregate demand back to the right in that case we'd move back to point a and the price level would go back to p1 but in our picture over time the short run aggregate supply curve shifted to the right as firms adjusted their expectations about the price level and what happened was the price level fell even more and we moved to a new long-run equilibrium at point c and then we're just going to sit there at point c in terms of incomes real gdp came back up where it started and so what we would experience as as real gdp goes from y2 back to y1 is that unemployment would be going down profits would be going up foreclosures would be going down as people's income returns back to where it started things get better and incomes go down and then come back up but in this picture price level fell typically what we see is that with recessions that are created by a shift in aggregate demand we tend to see those being deflationary they tend to drive the price level down if we think about kind of some historical times when this happened we could think about the early 1930s so if we're thinking about the 1930s what we saw there was real gdp fell gdp fell by about 27 close to a third was the decrease in um incomes real incomes we also saw unemployment of about um 25 a quarter of the people who wanted to work couldn't find a job price fell by about 22 percent and if you think about what happened with the great depression there are lots of different opinions amongst different groups of economists as to exactly what caused the great depression and there's there's overlap between different groups of economists but kind of the generally accepted explanation for what happened was that at the end of the 1920s the 1920s were great but at the end of the 1920s the stock market crashed and what ended up happening was that created this wave of pessimism and about the same time that happened there were some runs on banks there were some banks that started having problems and what ended up taking place was that even though the federal reserve existed at that time it didn't do its job and so people started pulling their money out of the banking system and that we know that when money gets pulled out of the banking system the um money supply is going to fall drastically and so what happened was the fed did not try to counteract that and so at the same time you've got people feeling very pessimistic about the future which shifts aggregate demand to the left you also had huge decreases in the money supply which also shifts aggregate demand to the left and so we saw then exactly what this model would predict we saw declines in real income we saw increases in unemployment that went along with that and we saw the price level fall if we think about the 1940s let's say the early 1940s at that point the um great depression was over and the thing that got us out of the great depression was the us entering world war ii and what happened when the us entered world war ii is that we had to gear up to fight a major war government spending increased by a lot and that shifts aggregate demand to the right so in the 40s we had an increase in aggregate demand because of world war ii so we had government spending increase by about five-fold it nearly doubled real gdp nearly doubled real gdp and think about what that means it nearly doubled real incomes in the u.s so when we see a increase in aggregate demand we would expect the opposite of what's happened here we would expect an increase in aggregate demand to drive the price level up and drive real gdp up which we saw there was also a 20 percent increase in the price level and unemployment went from about 17 down to one percent lowest it's been in the history of the us so unemployment fell to one percent there are lots of other minor recessions those are really good examples of recessions or expansions that are created by a shift in aggregate demand one of the challenging things is that with with any recession it's often hard to put your finger on exactly what's happened so if we were to look at the recession um the u.s has experienced many recessions um one of the last ones that we experienced prior to 2020 was the 2008-2009 recession and there are lots of opinions as to what led to that recession what was it there were dot-com failures there were problems in the housing markets there were a lot of different things that economists kind of debate as to what was the main cause and and that's what makes what has happened in 2020 very interesting because we know exactly what has happened here right the government has prohibited people from interacting economically the government essentially has put the economy into a deep freeze hoping that it can thaw it back out and so it has forcibly prevented transactions between people not all transactions but it's placed a lot of restrictions that prohibit many types of transactions so the other interesting thing about what's happened in 2020 is that it wasn't just created by a change in aggregate demand it was also created by a change in aggregate supply and we'll talk about that next so i'm going to clear this off and then we'll think about maybe running through a simple example of this without quite so much detail and then we'll do a shift in aggregate supply let's do another quick example of a change in aggregate demand but this time let's shift aggregate demand to the right so if we were to remember we're always going to be starting with a picture of long run equilibrium so we've got an aggregate demand curve i'm going to shift it so i'm going to call that one aggregate demand 1. price levels up here real gdp long run aggregate supply short run aggregate supply i'm also going to shift short run aggregate supply so we'll call that one put our initial equilibrium right here at point a here's our initial price level p1 and our initial level of real gdp y1 i'm not going to write out the story for all of this i'll just talk through it you it might be good to write it down in your notes just to kind of keep track of what's going on as we move through it let's suppose that instead of a decrease in aggregate demand let's suppose there's an increase in aggregate demand and that could be caused by um a stock market boom um it could be caused by the end of a war it could be caused by entering into a war an aggregate demand increasing because of an increase in government spending but for whatever reason let's suppose aggregate demand shifts to the right to aggregate demand curve two so we get a rightward shift in aggregate demand in the short run we're going to move to a long run excuse me a short run equilibrium right here at point b and the coordinates of that point show us that we're going to have an increase in real gdp to y2 and we're going to have an increase in the price level to p2 and this economy would be in what we would call an expansion now when we were thinking about a recession we talked about why the government might have an incentive to step in and try to end that recession clearly there would be no incentive to try to end things when things are going well so we wouldn't say well the government's going to try to you know decrease incomes back down but what will happen is that we know that this recession will end eventually because the price level has gone up and firms are going to expect to have to pay more for inputs in the future so as firms adjust their expectations of the price level this short run aggregate supply curve is going to shift to the left and it's going to shift to the left enough that we move to a new long run equilibrium right up here at point c so here's our new short run aggregate supply curve it's shifted to the left we move to a new long-run equilibrium at point c that occurs at an even higher price level of p3 and now our real gdp has gone back to y1 so in the short run when real gdp is up here at y2 incomes have gone up we would observe that unemployment has gone down profits will have gone up foreclosures would have gone down now income is back where it started there at y1 so the expansion is over and we've got an even higher price level so typically what we tend to see is that an expansion that's created by an increase in in aggregate demand tends to be inflationary so that gives you an idea notice that in what we've done right here and what we did right before this the long run aggregate supply curve never shifted because we didn't change technology we didn't change the amount of inputs that we've got so the amount our natural rate of output hasn't changed here and also notice that your long run equilibrium is always found on that long run aggregate supply curve okay in the short run we can move to a place to the right of that aggregate supply curve long run aggregate spiker or a place to the left but notice that the short run aggregate supply curve is in the long run going to shift to bring us back on to that long run aggregate supply curve so that gives you both a decrease in aggregate demand and an increase in aggregate demand let's talk about a shift in aggregate supply so let's say shift in aggregate supply now we could have some event that causes a permanent shift in aggregate supply meaning that let's say there's a war in your country and a lot of people get killed then that means there's fewer workers and in that case both your long-run aggregate supply and your short-run aggregate supply are going to shift to the left because now you can produce less output than before or we could have temporary decreases in aggregate supply so let's say a bad weather event let's say there's a a uh i don't know unusually high temperatures cause a decrease in agricultural production or something like that well that we would think of as a temporary decrease in aggregate supply in that case the long-run aggregate supply won't move but the short-run aggregate supply curve will okay we're going to think about that type of aggregate supply shift the type where short-run aggregate supply shifts and long-run aggregate supply does not and the reason we're going to do that is it's simpler so let's talk about that let's suppose that we draw a picture here where we've got our long-run equilibrium so we've got aggregate demand we've got our long run aggregate supply and we've got our short run aggregate supply let's call that short-run aggregate supply one let's start with our initial equilibrium right there at point a initial price level of p1 let's label our axes there's price level there's real gdp here's our initial level of income real gdp y1 so let's do a short story here we're going to start at a price level is equal to p1 real gdp is equal to y1 and now let's suppose that something drives up the cost of production for producers maybe it's that the price of oil causes the price of gas to go up as i said it could be an adverse weather event there are a lot of things that can cause temporary disruptions in producers ability to produce so let's shift our short-run aggregate supply curve to the left we get a decrease in short-run aggregate supply to short-run aggregate supply 2. so short-run aggregate supply decreases let's say suppose short-run aggregate supply decreases let's think about where we move in the short run in the short run the impact of this is going to be that our intersection of aggregate demand and short-run aggregate supply is going to be right here at point b and so we get a higher price level p2 and we get a lower level of real gdp we'll call it y2 so we move to point b in the short run we get an increase in price level and a decrease in real gdp and let's think about what's happening there so that's a recession real gdp has gone down notice that this is going to be a particularly painful type of recession if we were to go back to the first example that i went where or that i did where we had a decrease in aggregate demand what we saw was a decrease in aggregate demand sends the economy into a recession but it drives the price level down that's kind of like a silver lining you know the incomes are going down but at least the price level has fallen so you've everybody's got less money to spend but at least the prices of goods and services has gone down if we have a recession that's created by a shift in aggregate supply then not only do incomes go down but the prices of everything go up that's a really painful type of recession we've actually got a name for that we call this stagflation very painful type of recession it's the combination of of stagnation and inflation stagnation referring to incomes going down income growth becoming stagnant and inflation which is the price level going up okay so any type of recession that's caused by the supply side of the economy that's caused by a shift in aggregate supply those are going to be more painful than the recessions that are caused by the demand side of the economy a change in aggregate demand so let's think about what the government can do what can government do well there's not a lot of good options one possibility is that the government can increase government spending or increase the money supply to shift aggregate demand to the right and if the they did that and it shifted aggregate demand to the right we would move to a new long run equilibrium up here at point c but the problem with that is that that causes the price level to go up even more that's it it causes incomes to go back up but it causes more inflation and so you can't offset both of these things at the same time you can't go back to point a unless you just write it out so let's just say an increase in aggregate demand an increase in aggregate demand would increase real gdp i'm going to say y but also cause inflation if you think back to one of those basic principles of economics you'll remember that one of them was that in the short run there's a trade-off between unemployment and inflation and that's exactly what we're seeing right here you can't fix both of those if you want to decrease unemployment which would happen if you increased real gdp if you want to decrease unemployment comes at a price and the price is it's going to cause inflation they could remember increase aggregate demand that should be an increase in aggregate demand by increasing either government spending or the money supply okay the other thing is do nothing so let's say or do nothing eventually that adverse weather event that caused the decrease in aggregate supply eventually that will be over and the economy as the short-run aggregate supply curve shifted back to the right the economy would move back to point a so let's say eventually whatever caused the decrease in aggregate supply will be over and then we go back to point a here's the problem with that politicians are very hesitant to publicly choose this option and the reason is is that people tend to vote them out of office if they don't if they're not doing something that's an unfortunate thing for all of us because there are many times when it would be better for us all if the government did not do something not always but there are times when that's the case so the right thing for the government to do might be to not do anything because if they do something it's going to create a different problem or it's going to be a waste of money but they face a very strong incentive to to be proactive to try to do things and so they do tend to do things and sometimes it creates other problems sometimes it causes problems that we've got to become even worse um so if you're wondering well why is it that that politicians always do something when doing nothing might be the best thing well it's hard to just say hey you know what we're going to do nothing we know things are bad but the best thing to do is to do nothing if everybody had had an economics class and everybody understood the economics of how markets tend to work then that might be an easier sell but uh not everybody understands that so with uh stagflation that tends to be pretty painful i want to clear this off and then just kind of talk about what has happened with the the pandemic because actually what we've got in this particular case is the combination of a shift in aggregate demand and a shift in aggregate supply and it's caused things to be especially bad so let me clear this off and we'll take we'll finish up with that this aggregate demand aggregate supply model is really useful for trying to figure out what's going on in the economy and most of the time what we tend to see is that when the economy experiences expansions or or recessions that they're almost always caused by a change in aggregate demand or a change in aggregate supply it's pretty rare for both of those things to happen at the same time that's not to say that it doesn't happen but um it's not that common and what that means is that you know it's a lot of times easier to kind of diagnose what's happened and and you know it may not be easy to figure out exactly why aggregate demand decreased um sometimes you know if you look at the example we talked about earlier the great depression or the recession of 0.809 it economists debate what they think caused the changes in aggregate demand what we've had happen in 2020 is if we think about what's going on here we've had a change in aggregate demand and a change in aggregate supply and it was essentially government forced and so if we think about the price level and real gdp we've got our aggregate demand curve let's put our long run aggregate supply and our short run aggregate supply and our initial equilibrium at point a now what has happened is that the long run aggregate supply curve has not changed we haven't had a situation where we've lost a lot of natural resources or where the labor force has shrunk because we've had a war and a lot of people got killed that has not happened a overwhelming majority of the the deaths that have taken place have been amongst people that are already retired so the the labor force hasn't changed our natural rate of output hasn't changed but what has happened is that the government has essentially forced the closure of a majority of businesses in the economy and so what happens is when the government tells you you can't go out and engage in transactions then people quit spending their money and so what we've seen is that we've had a decrease in aggregate demand from aggregate demand one to aggregate demand two that's the first part but the government also forced down that forced the closure of most of the firms in the economy well that means those firms are not producing anything that's a decrease in short-run aggregate supply so these firms aren't producing less because of some adverse weather event they're producing less because the government has told them they can't be open and so we get a decrease in short-run aggregate supply draw it over here so there's short run aggregate supply 2. what that means is that we need to look at the intersection of our two two new curves and that intersection is going to be somewhere over here call it point b and what that means is we have a relatively large decrease in income and if we look at what's happened to real gdp and the picture will become clearer as we're able to get this farther in hindsight and we're able to actually look at what the data looks like what we're going to see is that this is going to create a very very large decrease in real gdp and it's easy to understand exactly what's going on this isn't a mystery we know what happened the government policy has put us into this situation and and there can be a lot of debate about whether or not the government should have taken those steps that's certainly available for debate but we understand exactly where those steps have put us we also understand fairly easily what's going to happen when those things are removed so if the government were to remove those restrictions then the short-run aggregate supply curve would shift back aggregate demand eventually would shift back and we'd move back to point a now how long that takes nobody knows that is something that is yet to be seen and it will certainly depend upon whether firms can open the extent to how much they can sell once they are open if if you make your money selling seats in a theater and all of a sudden the government tells you that you can only have 30 of the seats that you could before you're not going to be able to make as much money as you could before and so you're not going to be able to sell as many seats and so as the economy starts to reopen and we start to see what restrictions get lifted and what new restrictions might get put into place we're going to see what what type of of recovery we have but the nice thing about this recession is it's easy to understand what put us at point b now where we go from point b we'll have to see as i said so this is a relatively interesting and unusual type of recession but again this aggregate demand aggregate supply model is very useful for thinking about how changes in government spending will affect the economy how changes in weather events how terrorist attacks or a virus how those things might impact the economy this is a very useful model for understanding what causes recessions what causes them to happen what causes them to end what we'll do in our final section of material that we're going to cover in our next set of videos is that we're going to look specifically at the aggregate demand curve and the impact that changes in the money supply have so we'll take a look at that in our next video i'll see you then