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- [Mary Clare] Today we're going to do a deep dive into the mechanics
of the aggregate demand-- aggregate supply model
so that we understand
what all the curves and notation mean.
Let's start at the beginning.
What are we actually measuring in this economy?
On the vertical axis, we'll measure the economy's inflation rate
denoted by the Pi symbol.
This is the percentage change in an economy's average price level
in a given year.
And on the horizontal axis,
we'll track the economy's real GDP growth rate.
But before we get into the causes
of the booms and the busts of an economy,
we have to know what the economy's normal GDP growth rate is, right?
That's the long-run aggregate supply curve.
It's the vertical line,
because an economy's long-run growth rate
shouldn't depend on inflation.
Instead, it should depend
on the fundamental factors of production --
technology, capital, and labor.
So we can treat the LRAS curve
like the North Star of economic growth.
The economy will tend to return
to this level of economic growth over time,
assuming no changes in the fundamentals.
Now let's derive the aggregate demand curve
from the quantity theory of money.
Recall that the money growth rate plus velocity growth rate
equals inflation rate plus real GDP growth rate.
The AD curve is all the combinations
of the inflation rate and the real growth rate
that add up to a constant amount.
So, for example, say money growth is 4%
and velocity is 1%, for a total of 5%.
Then any combination of inflation and real GDP growth
must add to 5%.
Alternatively, since the inflation rate
plus the growth rate of real GDP
is the growth rate of nominal GDP,
we can also say that the AD curve shows all the combinations
of inflation and real growth
which give the same growth rate of nominal GDP.
So how does the AD curve shift?
The AD curve will shift
if there's a change in the money growth rate, "M,"
or the change in velocity growth, "V."
The central bank affects money growth.
Government spending,
and consumer and investor confidence
can effect velocity growth.
So we have our supply and demand curve,
but we also need a short-run supply curve
that looks like this.
Let's dig in to why we need a short-run supply curve.
Suppose that the government
slows down the growth rate of the money supply
such that AD shifts to the left, like this.
The fundamental factors of production haven't changed,
so in the long run we'll move to point C.
But notice that at point C
the inflation rate is lower than at point A.
Unfortunately, it's difficult for the economy
to move from A to C
without reducing real growth in the short run.
Why is that?
Because prices and wages are sticky.
Imagine that your boss came into your office one day
and just says, "Hey, the central bank is slowing money growth,
so you won't be getting a raise this year."
You'd probably be pretty upset -- even if your boss told you
that since prices will also be lower
you won't be worse off.
Similarly, imagine that you told your boss
that you thought the firm shouldn't raise prices this year
because the growth rate of the money supply had fallen.
Your boss might complain that she has to raise prices
because her input prices are still increasing.
In theory, if workers and firms
all agree to lower wages and prices at once --
kind of like we sometimes agree
to change the clocks at the same time --
we could move to point C quickly.
But it's just not that easy
to coordinate an entire economy in this way.
Since wages and prices don't all move at once,
it takes time to adjust to our new equilibrium,
and the adjustment process creates a painful reduction
in the growth rate of real GDP.
So, in the short run, we move from point A to point B.
Now eventually we'll get back to our North Star growth,
but it will take time for everyone to recognize
that lower inflation rate,
and adjust their wage and price demands appropriately.
Now when we finally do return
to our long-run equilibrium at point C,
everyone will now expect that newer lower rate of inflation
as denoted by the Pi equals 2%,
which means workers and firms now expect an inflation rate of 2%,
and make their decisions based on that expectation
rather than the previous expected inflation rate of 4%.
So we can also say that short-run recession occurs
because at point A people are planning
and making decisions,
expecting that an inflation would be 4%,
and when that expectation turns out to be false,
it takes time to adjust those plans, decisions, and expectations
to the new inflation rate of 2%.
Now, it's important to realize that this is just a model,
and a model tells us things like, "if x happens, then y will happen,"
or, "if q happens, then z will happen."
But by itself, the model doesn't tell us
if q or x are happening.
For example,
the Great Recession was, in part, caused
when housing prices fell dramatically,
causing people to cut back on their spending --
a fall in the growth rate of V.
Now the model tells us what to expect when V falls,
but it takes time to figure out that that was actually going on
in 2008 and 2009.
As always, please let us know what you think.
And if you want to challenge yourself some more,
check out our Practice Questions at the end of this video.
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