WEBVTT

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- [Instructor] In our last video,

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we talked about the states
of short run equilibrium

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that a country's economy could experience.

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We showed in AD/AS graphs,
what positive output gaps

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and what negative output gaps look like.

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In this video, we're going
to actually step back

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a little bit and talk about the factors

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that could cause positive and
negative output gaps to occur

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in a country.

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The term we're gonna be
talking about in this video

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is shocks to aggregate
demand and aggregate supply.

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We're gonna use some graphs to illustrate

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both positive and negative
demand and supply shocks

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and talk about how a
country's economy will adjust

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in the short run to a new
equilibrium following a shock

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to either AD or AS.

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Let's start with the
definition of demand shocks.

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We'll actually define
positive demand shocks first,

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and then we'll show the effect

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that a positive demand shock would have

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on a country's economy.

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A positive demand shock occurs
anytime there is an increase

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in AD resulting from an
increase in either consumption,

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investment, government
spending, or net exports.

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If aggregate demand
increases due to an increase

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in one of the different
national expenditures,

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we can show the effect that
this will have in the short run

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in our AD/AS graph.

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So let's assume that due to an
increase in household wealth

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as a result of rising home prices,

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households decide to consume
more goods and services

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at every price level.

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This causes an increase in
aggregate demand to AD1.

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Now, let's look at the
effect that this would have

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on the nation's economy,

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assuming there is no
change in the price level

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and then assuming the price level adjusts

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to the new level of aggregate demand.

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This will look quite
familiar to any student

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who has already studied microeconomics

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and knows that if demand for
a particular good increases

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and there is no corresponding
increase in the price

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of that good, then we will have

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what's called a disequilibrium
in the short run.

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And the same is true on
a macroeconomic level.

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If aggregate demand

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due to increased household
wealth and consumption

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and there is no increase in prices,

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there will be a quantity
of output demanded

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that is greater than the
quantity of output supplied.

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So here we have a disequilibrium.
There will be a shortage.

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This would be a shortage
of goods and services

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in the United States if
aggregate demand increases

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and there is no corresponding
increase in the price level.

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So just like in microeconomics,

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if there is a disequilibrium in a market,

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that market must adjust

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in the form of rising prices in this case.

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So demand pull inflation will result

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from a positive demand shock.

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Demand pull inflation is
a rise in the price level

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resulting from an increase
in aggregate demand.

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Here we can see that here

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we have a new equilibrium
price level of PL2.

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The higher price level
of goods and services

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incentivizes businesses
to increase the quantity

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of output that they produce,

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and it reduces the quantity of
output demanded by households

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who previously had increased
the amount of output

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they demanded due to rising wealth.

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And we achieve a new
equilibrium, I'll call this YE1,

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a new equilibrium at
the intersection of SRAS

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and aggregate demand.

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In the short run, an
increase in aggregate demand

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will cause an increase in
output beyond full employment

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and an increase in the
average price level,

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this is called demand pull inflation

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and an increase in the
quantity of output demanded

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and supplied in the economy.

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A positive demand shock occurs

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when aggregate demand increases.

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That of course, means that
a negative demand shock

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when there is a decrease in AD

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resulting from a decrease
in consumption, investment,

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government spending, or net exports.

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Let's assume, for example,

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that interest rates rise in the economy

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leading firms to demand

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less new capital equipment and technology

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causing a decrease in
private sector investment.

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Falling investment means
that at every price level,

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there will be a smaller quantity of goods

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and services demanded by the
nation's firms and households.

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So what happens if the price level remains

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at the original price level of PLE?

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Well, there would be, once
again a disequilibrium.

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The quantity of output
demanded, I'll call that YD,

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would be less than the
quantity of output supplied,

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resulting in a surplus of
goods and services produced

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in this country.

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To restore equilibrium,

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the equilibrium price level must fall

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leading to an increase in the
quantity of output demanded

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by households and firms and
the government and foreigners,

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and a decrease in the
quantity of outputs supplied

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by the nation's producers.

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As the price level falls,

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we're gonna see a new equilibrium at PL2

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and a new equilibrium
level of output at YE1.

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A negative demand shock
causes what we call deflation.

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This is a fall in the average price level

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or, depending on the level of
inflation at full employment,

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this might just be a fall
in the inflation rate,

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which is known as disinflation.

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In other words, if
inflation is still positive,

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but it's just lower than it was

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while the economy is at full employment,

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then we don't see prices actually fall,

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we just see lower rates of inflation.

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A negative demand shock
causes a decrease in output,

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a decrease in the price level,

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and a new equilibrium
level of national output

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below the original equilibrium.

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And of course, this economy
now has a recessionary gap.

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We talked about recessionary
gaps in the previous video.

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So recessionary gaps can be caused

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by negative demand shock,

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inflationary gaps can be caused
by a positive demand shock.

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Alright, let's move on and talk about

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aggregate supply shocks.

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This time, we're gonna start

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with negative aggregate supply shocks.

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A negative aggregate supply shock

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occurs whenever there is an increase

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in the costs of production in a country

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which causes a decrease in
short run aggregate supply.

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So assume, for example,
there's an unexpected increase

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in energy prices.

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All businesses, no matter
what they're producing,

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depend on electricity.

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So if electricity prices go up,

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we would expect to see an inward shift

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of the short run aggregate supply curve

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as it costs more to produce
all goods and services.

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Now, if the price level were
to remain the same, at PLE,

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there would be shortages

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of goods and services in this country

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as the quantity of output
supplied, I'll call that YS,

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is less than the quantity
of output demanded.

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This would represent a
shortage of goods and services.

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However, the economy should adjust

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to a new equilibrium price level

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and level of national output.

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And it does so by prices rising.

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We should see a new
equilibrium price level,

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which causes an increase
in the quantity supplied

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from what would occur at the
original price level of PLE,

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and a decrease in quantity
of output demanded,

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and we achieve a new equilibrium
at a higher price level.

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This is inflation,

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just like we saw in the
positive demand shock

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section of this video.

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However, this is not
demand pull inflation.

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This type of inflation is what
we call cost push inflation.

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Cost push inflation
results from an increase

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in the costs of production in a country

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and a decrease in aggregate supply.

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This cost push inflation causes a decrease

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in national output, and we
have a new equilibrium at YE1.

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Now we do have a recessionary
gap here as well.

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However, this recessionary
gap is not caused

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by decreasing demand
for goods and services,

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rather decreasing supply.

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Now of course, there can
be positive supply shocks,

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positive supply shock.

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This would be when
aggregate supply increases

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due to falling costs of production.

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Assume for example, that the government

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enacts a massive policy of deregulation

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in the United States.

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Firms can now produce in the cheapest,

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most environmentally
harmful manner imaginable

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and as a result, at every price level,

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firms in the United States wish to produce

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a greater quantity of output.

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So we see an increase in
short run aggregate supply

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to SRAS1.

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Assume once again that
the price level remains

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at its original level of PLE.

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If the price level did not
fall following the increase

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in aggregate supply,

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we would have a quantity of
output supplied, that's YS

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that is greater than the
quantity of output demanded,

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we would have surplus output.

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Just like in microeconomics,

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if there is a surplus
of goods being produced,

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the price must fall.

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In macro, the price level must fall.

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And as it does, households, firms,

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the government and foreigners will demand

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a greater quantity of output

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and will achieve a new equilibrium.

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So this is the new
equilibrium. Call that PL2.

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Here we see, once again, prices falling.

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This could be deflation

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or depending on the rate of inflation

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before the positive supply
shock, it could be disinflation,

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a lower inflation rate.

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And as price levels fall,
we achieve a new equilibrium

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level of national output at YE1.

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Alright, we've just walked
through four different scenarios.

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We talked about a positive demand shock,

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which causes an increase
in aggregate demand,

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leading to demand pull inflation,

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and an increase in the
equilibrium level of output.

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We also talked about a
negative demand shock,

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which causes disinflation or deflation,

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and a decrease in national output

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resulting in a recessionary gap.

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Next, we moved on to supply shocks.

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A negative supply shock caused
by an unexpected increase

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in the costs of production in a country

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causes cost push inflation.

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That's higher prices
and a recessionary gap

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as the equilibrium output
falls in a country.

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A positive supply shock

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caused by something like deregulation

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or any other thing that
causes the cost of production

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in the country to fall causes
deflation or disinflation

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and an increase in the equilibrium
level of national output.

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So an increase in short
aggregate supply is the best

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of the four scenarios we
outlined in this video

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for a country.

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It actually means that the
country is experiencing

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economic growth, increased output,

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and price level stability.

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In the next video, we're gonna talk about

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long run adjustments to a
country's aggregate output

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in the AD/AS model.

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(upbeat music)
Here we go.