Office Hours: Using the AD-AS Model

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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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