Demand and Supply Shocks in the AD-AS Model

- [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.