- [Instructor] In our last video,
we talked about the states of short run equilibrium
that a country's economy could experience.
We showed in AD/AS graphs, what positive output gaps
and what negative output gaps look like.
In this video, we're going to actually step back
a little bit and talk about the factors
that could cause positive and negative output gaps to occur
in a country.
The term we're gonna be talking about in this video
is shocks to aggregate demand and aggregate supply.
We're gonna use some graphs to illustrate
both positive and negative demand and supply shocks
and talk about how a country's economy will adjust
in the short run to a new equilibrium following a shock
to either AD or AS.
Let's start with the definition of demand shocks.
We'll actually define positive demand shocks first,
and then we'll show the effect
that a positive demand shock would have
on a country's economy.
A positive demand shock occurs anytime there is an increase
in AD resulting from an increase in either consumption,
investment, government spending, or net exports.
If aggregate demand increases due to an increase
in one of the different national expenditures,
we can show the effect that this will have in the short run
in our AD/AS graph.
So let's assume that due to an increase in household wealth
as a result of rising home prices,
households decide to consume more goods and services
at every price level.
This causes an increase in aggregate demand to AD1.
Now, let's look at the effect that this would have
on the nation's economy,
assuming there is no change in the price level
and then assuming the price level adjusts
to the new level of aggregate demand.
This will look quite familiar to any student
who has already studied microeconomics
and knows that if demand for a particular good increases
and there is no corresponding increase in the price
of that good, then we will have
what's called a disequilibrium in the short run.
And the same is true on a macroeconomic level.
If aggregate demand
due to increased household wealth and consumption
and there is no increase in prices,
there will be a quantity of output demanded
that is greater than the quantity of output supplied.
So here we have a disequilibrium. There will be a shortage.
This would be a shortage of goods and services
in the United States if aggregate demand increases
and there is no corresponding increase in the price level.
So just like in microeconomics,
if there is a disequilibrium in a market,
that market must adjust
in the form of rising prices in this case.
So demand pull inflation will result
from a positive demand shock.
Demand pull inflation is a rise in the price level
resulting from an increase in aggregate demand.
Here we can see that here
we have a new equilibrium price level of PL2.
The higher price level of goods and services
incentivizes businesses to increase the quantity
of output that they produce,
and it reduces the quantity of output demanded by households
who previously had increased the amount of output
they demanded due to rising wealth.
And we achieve a new equilibrium, I'll call this YE1,
a new equilibrium at the intersection of SRAS
and aggregate demand.
In the short run, an increase in aggregate demand
will cause an increase in output beyond full employment
and an increase in the average price level,
this is called demand pull inflation
and an increase in the quantity of output demanded
and supplied in the economy.
A positive demand shock occurs
when aggregate demand increases.
That of course, means that a negative demand shock
when there is a decrease in AD
resulting from a decrease in consumption, investment,
government spending, or net exports.
Let's assume, for example,
that interest rates rise in the economy
leading firms to demand
less new capital equipment and technology
causing a decrease in private sector investment.
Falling investment means that at every price level,
there will be a smaller quantity of goods
and services demanded by the nation's firms and households.
So what happens if the price level remains
at the original price level of PLE?
Well, there would be, once again a disequilibrium.
The quantity of output demanded, I'll call that YD,
would be less than the quantity of output supplied,
resulting in a surplus of goods and services produced
in this country.
To restore equilibrium,
the equilibrium price level must fall
leading to an increase in the quantity of output demanded
by households and firms and the government and foreigners,
and a decrease in the quantity of outputs supplied
by the nation's producers.
As the price level falls,
we're gonna see a new equilibrium at PL2
and a new equilibrium level of output at YE1.
A negative demand shock causes what we call deflation.
This is a fall in the average price level
or, depending on the level of inflation at full employment,
this might just be a fall in the inflation rate,
which is known as disinflation.
In other words, if inflation is still positive,
but it's just lower than it was
while the economy is at full employment,
then we don't see prices actually fall,
we just see lower rates of inflation.
A negative demand shock causes a decrease in output,
a decrease in the price level,
and a new equilibrium level of national output
below the original equilibrium.
And of course, this economy now has a recessionary gap.
We talked about recessionary gaps in the previous video.
So recessionary gaps can be caused
by negative demand shock,
inflationary gaps can be caused by a positive demand shock.
Alright, let's move on and talk about
aggregate supply shocks.
This time, we're gonna start
with negative aggregate supply shocks.
A negative aggregate supply shock
occurs whenever there is an increase
in the costs of production in a country
which causes a decrease in short run aggregate supply.
So assume, for example, there's an unexpected increase
in energy prices.
All businesses, no matter what they're producing,
depend on electricity.
So if electricity prices go up,
we would expect to see an inward shift
of the short run aggregate supply curve
as it costs more to produce all goods and services.
Now, if the price level were to remain the same, at PLE,
there would be shortages
of goods and services in this country
as the quantity of output supplied, I'll call that YS,
is less than the quantity of output demanded.
This would represent a shortage of goods and services.
However, the economy should adjust
to a new equilibrium price level
and level of national output.
And it does so by prices rising.
We should see a new equilibrium price level,
which causes an increase in the quantity supplied
from what would occur at the original price level of PLE,
and a decrease in quantity of output demanded,
and we achieve a new equilibrium at a higher price level.
This is inflation,
just like we saw in the positive demand shock
section of this video.
However, this is not demand pull inflation.
This type of inflation is what we call cost push inflation.
Cost push inflation results from an increase
in the costs of production in a country
and a decrease in aggregate supply.
This cost push inflation causes a decrease
in national output, and we have a new equilibrium at YE1.
Now we do have a recessionary gap here as well.
However, this recessionary gap is not caused
by decreasing demand for goods and services,
rather decreasing supply.
Now of course, there can be positive supply shocks,
positive supply shock.
This would be when aggregate supply increases
due to falling costs of production.
Assume for example, that the government
enacts a massive policy of deregulation
in the United States.
Firms can now produce in the cheapest,
most environmentally harmful manner imaginable
and as a result, at every price level,
firms in the United States wish to produce
a greater quantity of output.
So we see an increase in short run aggregate supply
to SRAS1.
Assume once again that the price level remains
at its original level of PLE.
If the price level did not fall following the increase
in aggregate supply,
we would have a quantity of output supplied, that's YS
that is greater than the quantity of output demanded,
we would have surplus output.
Just like in microeconomics,
if there is a surplus of goods being produced,
the price must fall.
In macro, the price level must fall.
And as it does, households, firms,
the government and foreigners will demand
a greater quantity of output
and will achieve a new equilibrium.
So this is the new equilibrium. Call that PL2.
Here we see, once again, prices falling.
This could be deflation
or depending on the rate of inflation
before the positive supply shock, it could be disinflation,
a lower inflation rate.
And as price levels fall, we achieve a new equilibrium
level of national output at YE1.
Alright, we've just walked through four different scenarios.
We talked about a positive demand shock,
which causes an increase in aggregate demand,
leading to demand pull inflation,
and an increase in the equilibrium level of output.
We also talked about a negative demand shock,
which causes disinflation or deflation,
and a decrease in national output
resulting in a recessionary gap.
Next, we moved on to supply shocks.
A negative supply shock caused by an unexpected increase
in the costs of production in a country
causes cost push inflation.
That's higher prices and a recessionary gap
as the equilibrium output falls in a country.
A positive supply shock
caused by something like deregulation
or any other thing that causes the cost of production
in the country to fall causes deflation or disinflation
and an increase in the equilibrium level of national output.
So an increase in short aggregate supply is the best
of the four scenarios we outlined in this video
for a country.
It actually means that the country is experiencing
economic growth, increased output,
and price level stability.
In the next video, we're gonna talk about
long run adjustments to a country's aggregate output
in the AD/AS model.
(upbeat music) Here we go.