Let's make a plot of real GDP
as a function of time.
This axis right over here is going to be
real GDP, so it's an actual measure,
not just nominal GDP.
It's an actual measure of the goods and services
produced by an economy or
the productivity of an economy.
Over here let's have time.
In our little country or whatever economy
we're studying here, let's assume
that over time its population is growing.
Let me write these things down.
So, population is growing over time,
and this is not an unrealistic assumption,
this is true of most countries.
Population is growing over time.
Also, let's assume that productivity is improving.
Productivity ... Productivity is just
essentially how much can each individual
person produce?
Productivity.
Productivity is going up.
Productivity goes up due to technology,
probably mainly technology,
technology
Mainly technology, but there could be
discoveries of resources.
Discovery of resources ...
Or it could be new business processes.
People wouldn't even consider that
maybe technology, so new processes.
On a per person basis, they're able to
produce more and more over time.
Because of these trends, and these are
trends that do take place over
long periods of time in many, many economies,
you would expect the real productivity
of that economy to increase.
If you were to just do the long-term
trend just based on these two things,
the population growing and productivity improving,
over time, real GDP should have a trend
something like that.
That is the long-term trend of most
properly functioning economies.
When you look at it on the short-term,
it doesn't look like a nice, smooth
trend line like this.
When you study any major economy in the world,
or any economy, any normal economy,
instead of going this nice, smooth trend line,
it tends to look something more like this.
Real GDP will be going really fast,
maybe higher than trend line,
and then all of a sudden,
it will essentially recede,
or it will essentially shrink.
Then it'll start growing again,
maybe go above the trend line,
then it'll recede ... Go below the trend line.
Then it'll go above the trend line,
it'll just keep fluxuating around
a trend line like that.
This fluxuation around this trend line,
this is called the business cycle.
This right over here ... And you could maybe
call one cycle, you could say it's from
one peak to one peak or
one trough to one trough,
or whatever you want to call it,
it's this idea that the economy isn't
just a nice, steady-as-you-go growth,
you have periods of fast growth
going maybe above the trend line,
and then it recedes, then it expands,
then it recedes.
This is the business cycle.
Business cycle.
The term "cycle" is a little bit misleading.
Whenever you think of a cycle,
even the way I drew it, it kind of looks like
a nice well-defined pattern and every
the same amount of years you're going
up and down, it kind of implies that
it's predictable.
The reality is that the business cycle
is very unpredictable.
And economists more than anyone
have trouble predicting the business cycle.
When you think of a cycle,
it's not this nice, sinusoid pattern,
it's much, much more unpredictable.
It does fluxuate up and down above
a trend, but it's hard to predict.
Hard to predict.
In general, you don't have the same
period of time between every peak
and every trough.
That is why it is so hard to predict.
There are different terms for different
phases of the business cycle.
I kind of used it just in describing
what was happening.
Over here, where the economy is growing,
so the economy is growing from there to there,
from there to there, we would call this
phase of the business cycle,
I'll highlight that in green,
we would call that expansion
because the economy is literally expanding.
There's more goods and services being
produced in that economy.
Then when, and we'll talk about the
reasons why this is happening,
and then when it starts to shrink,
the economy starts to shrink,
this right over here, or you could call it "recedes",
if you think of it in a title analogy,
this right over here is called a "recession".
This right over here is a ...
So that purple part right over there,
is a recession.
If a recession is bad enough,
it is sometimes categorized as a "depression",
and there's different categories for a depression;
there's the famous joke,'
"When your neighbor loses his job, it's a recession.
When you lose your job, it is a depression."
The interesting thing is we see this pattern
happening, whether it's every 8 years,
7 years, every 10 years,
but we don't fully understand exactly
why it's happening.
What we're going to try to attempt to do
in the next few videos is look at models
that do attempt to explain it.
That's actually the whole purpose
why we're going to study aggregate demand
and aggregate supply.
With that said, I want you to view those
models with a huge grain of salt
because those are, I would argue,
overly simplified economic models
that don't take into consideration
probably the most important factor
in the economic cycle or any type
of market cycle, and that is human emotions.
Human emotions.
You might notice in most of our studies
of economics so far, we haven't really
talked a lot about human emotions or
human's tendencies to extrapolate
the recent past, or human's greed
or risk of fear and greed, and all of these things,
that are very real things because
in traditional economics, they don't
fit neatly into the models.
There are new fields in behavioral economics
and behavioral finance that do try to
take into account things like human emotions,
but it's not going to make its way into
the models that we're going to study
in aggregate supply and aggregate demand.
The reason why I say human emotions,
and because just based on,
I spent I think it was six or seven years
in markets while I was an analyst at
an investment firm, it was very clear to me
that what drove market cycles and
economic cycles to a large degree,
was based on human emotions.
That what you have happening over here
is that the longer time,
once again, this isn't what you would
classically learn in your freshman economics
class, I'm just going to say this ...
Before we start studying the classical
one, because I think this does give a better sense
of what's probably happening in an economic cycle.
Right over here when the expansions
phase is starting, people are still skeptical.
They've just been through this,
people were getting laid off over here,
people were losing their jobs,
people were having trouble paying the bills,
companies had very low profits or maybe
no profits at all,
bankruptcies were occurring,
so even though the economy is starting
to expand right over here,
people were kind of skeptical.
In the recent past, they remember all of this pain
so they don't want to go out there
and start spending money.
They don't want to go out there
and start investing.
The further and further they go from that point,
and I'm just explaining the emotional
aspect of the economic cycle which I think
is probably the most powerful one,
the further and further they go away from this,
they say maybe this is for real.
Maybe this is really happening.
Their memories of that pain are
more and more distant.
Their memories of all the risk,
the memories of all the layoffs
and the bankruptcies become
more and more distant
and then they become more and more confident
and more and more eager to invest.
They start investing and
spending more and more,
they start hiring,
and because of all of that,
they see fewer and fewer bankruptcies,
fewer and fewer layoffs,
hiring is starting to occur,
people are getting more and more and more
optimistic, so the economy keeps growing.
When you go to points right around here,
it's been a long time since anyone really
talked about major layoffs and bankruptcies,
and foreclosures and all the rest.
People over here are feeling super, super confident
and they're probably underplaying risk
at this point.
They're investing money,
they're spending money like there's no tomorrow
because they think there will always be
good growth.
They're essentially extrapulating
the recent past.
They think, and there's actually even
been studies that show that even economists,
when you ask them at this point,
what's the foreseeable future going
to look like, they tend to extrapulate
the recent past.
They say the recent past, we were growing
like that, so in the future we will grow like that.
At this point, essentially people are
being too bullish, they're being too optimistic
and they're probably misallocating investment.
As soon as things don't grow as people
expect, they start getting a little bit fearful,
but they're still in denial at this point,
they get a little bit more fearful,
but here they say,
"Oh my God, something is going on."
They start panicking, layoffs start happening,
economy recedes and then we have
the entire cycle again.
To kind of understand this emotional aspect
of it, this is something I redrew.
I redrew a graph that always gets kind of
chain mailed around or sent around
usually during every bubble when
people start becoming skeptical
of the growth and economy.
It traditionally refers to stock market cycles.
Stock market cycles are closely linked
to actual economic cycles.
I think these words really do capture
the emotional sentiment of what's going on
in either during the business cycle
or during a stock market cycle.
Right when we're in the middle of an expansion,
people are pretty optimistic.
A little bit further into it,
people are feeling excitement.
They're saying, "Maybe this is a new type of thing.
Maybe we're going to be able to grow forever."
Then there's a thrill that people,
just the last few years,
all they do is they remember making money.
They say, "I'm going to put all my money
in the stock market. I'm going to start
buying Pets.com and whatever else."
Then there's euphoria.
They're just like, "Wow, easy money.
I don't have to work for a living.
I can just keep flipping houses or
buying stocks of Pets.com," or whatever else,
day trading.
Then all of a sudden, you have some signs
that maybe there was some bad investment,
that people's investments weren't turning
out as good as they expected.
People get a little anxious, but then as you
still foresee this, they start denying it.
Some people say, "Are we in a recession thing?"
"No, no, no, no, we're not in a recession.
It's been so long since we were in a recession.
Things are different this time.
The internet changes everything.
Housing never goes down."
But then as it continues,
as the recession really does continue,
they start to get fearful, they start saying,
"Maybe this is something going on,"
then desperate, then panic,
and that's when people really,
if you think of a stock market cycle,
really start to sell in the case of a
regular business cycle,
they start to maybe underspend,
they start to really hoard things,
then capitulation ... This is when they say, '
"Things are just bad. They're never going
to get any better," and then they become
despondent and eventually, you could even say,
emotionally people start getting depressed
because they say it's been so long since
we've felt all of these good emotions
right over here.
As any good investors will tell you,
"This is the best time to invest."
"This is the worst time to invest."
Even though there's maybe a little bit
of growth right over here,
it's been so long since we've experienced
all of these emotions. People are depressed,
but then as the growth continues,
They start to feel hopeful, a little relieved,
they say, "At least we're not getting
worse and worse," and then you get
back to optimism again.
So keep this in mind because
in my mind, the emotions really are
the main factor that are playing in
either stock market cycles or economic cycles.
We we study it kind of classically
in an economics class, we're going to take
human emotions a bit out of the picture,
which is a little bit artificial because
they might be the most important part of the picture.