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[Alex] Last time, we introduced the aggregate demand curve.
Today, we're going to add the long-run aggregate supply curve
to our model.
We're also going to show
how real shocks can generate business fluctuations.
Let's bring back some familiar characters:
"A", "L", and "K".
Earlier we saw that the key to a country's economic growth
was combining human and physical capital
with ideas and good institutions.
So, every economy has a potential growth rate,
given by these fundamental factors.
Now do any of these fundamental factors
depend upon the rate of inflation?
No -- at least not in the long run.
The long-run aggregate supply curve
shows an economy's potential growth rate
when all is going well.
Thus, the long-run aggregate supply curve --
it's very simple -- just a vertical line
at the economy's potential growth rate,
or "Solow" growth rate --
the rate given by the fundamental factors of growth.
That's the long run.
We'll say more about the short run in a later video.
We now have the aggregate demand curve,
and the long-run aggregate supply curve.
In this specific example,
notice that spending is increasing at a rate of 10% per year,
and the real economy is growing at 3% per year.
So inflation is 7% per year.
How can we use this simple model
to help us to understand business fluctuations?
Let's revisit how the U.S. economy has grown over time.
On average, it grows at a rate of about 3% per year.
But there are lots of fluctuations around this average.
How come?
One reason is that there are shocks to the key growth factors,
shocks that continually buffet the economy.
The supply of oil might leap up, or leap down.
The weather can be an important positive or negative shock,
especially in agricultural economies.
We call shocks like this
because they directly affect how the factors of production
are transformed into output.
Even in developed economies,
a bad hurricane, like Hurricane Sandy --
that can slow growth for a quarter or two.
It's hard to run a factory, for example,
when the factory has been flooded.
Even factories far from the center of the hurricane --
they may have to slow down
if they can't get parts, for example.
Wars, or big changes in taxes, or regulations,
or other government policies, can also shock the economy,
as can changes in ideas, or technology.
Weather shocks are easy to see.
But keep in mind that the fundamental forces
that drive an economy --
they're not always operating in smooth ways.
Some days while working in my office, for example,
I have a good idea!
And my research output?
It leaps forward!
And other days, I just can't seem to get anywhere,
or produce anything.
Sometimes, it's even negative production!
Economic growth is like that.
Over time, ideas accumulate, and we do get progress.
But it's not always a smooth process.
Growth naturally comes in fits and starts.
Real shocks in one area of the economy
can also be amplified and transmitted
to other areas of the economy.
A shock to the banking sector, for example,
can be amplified and transmitted to other sectors.
And if the shocks are big enough -- yes, recessions,
and even depression can be the result.
Now how would a real shock be represented
in our AD-AS model?
A negative shock
shifts the long-run aggregate supply curve to the left,
which lowers growth
and increases the inflation rate.
A positive shock
shifts the long-run aggregate supply curve to the right,
which increases growth
and reduces the inflation rate.
Of course an economy -- it's experiencing lots
of positive and negative shocks all the time.
And over time, we'll see a process that looks like this.
So now we have one source of business fluctuations:
real shocks.
These are shocks that shift
the long-run aggregate supply curve.
In the next video,
we're going to turn to a second source of shocks --
aggregate demand shocks,
or what John Maynard Keynes called
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