Here I am back for a second part of this video on aggregate demand and aggregate supply and then the last part I described the aggregate demand and aggregate supply curves and I drew this nice messy diagram here but basically explaining that aggregate demand is downward sloping just like a normal demand curve but an aggregate supply curve there are different ways people explain this some people have an aggregate supply curve that slopes upward but then they have this brick wall that’s a third curve they put in here that’s potential GDP basically I’d rather can put it all in just two curves here where you have aggregate demand representing consumer investment government and business spending at different price levels and aggregate supply representing the productive capacity of the country and as we have seen this is this all comes from empirical evidence and also a little bit of common sense that if that you have three regions of an aggregate supply curve one region is relatively flat where you have high unemployment and lower GDP and as you produce more there’s not much pressure for price to go up there on the other end there is a a limit to how much we can produce and if you try to stimulate demand up beyond that region then you’re gonna hit up a brick wall and you’re not gonna be able to do anymore so let me let me delete some of this stuff here so and so that’s this red section that is the vertical part straight up and down if you try to push the economy too far too fast then you will hit this brick wall and you will just succeed in raising prices but you can’t produce anymore GDP and then there’s this intermediate region here where you can increase GDP some while also in increasing prices some and so this is green region is kind of the region where we normally try to target the economy we try to steer the economy so that we are a higher GDP than the blue region but a lower GDP than the red region and so we try to steer the boat in between these two dangerous rocky shores here so in the middle what we’re saying is we’re willing to take a little bit of increases in price as as demand increases in this region but there’s a payoff a little bit of inflation gives us a little bit of GDP payoff but at some point as you travel up the steeper and steeper curve you get less and less increases in real GDP and more increases in inflation and at some point we we don’t want to keep going down that path so let’s let’s talk about a few other specific points that can derail this sort of simplistic notion about what goes on so let’s look at a few details here and let’s look at some Keynesian perspectives as well so one thing I want to talk about briefly here is the ideas that Keynes taught us so before the Great Depression in the US and and also world wild were world wide that most people say started somewhere around 1929 after that Great Depression Keynes was one of the big thinkers that tried to guide us and think about what’s going on and he introduced the following he a lot of ideas but the three ideas I like to focus on are number one the circular flow of people spending and then they give their money to businesses businesses produce products and then they pay their employees and and other people and the money just kind of keeps going around in a circle in the economy we call that the circular flow that that can break down because of saving and invest behavior by consumers and businesses and so what we’re talking about here is something cans can make people panic sometimes businesses could panic or people can panic and if they think that mccain’s Keynes sometimes used in a term like animal spirits animal spirits is emotional behavior people start to think that there’s a problem or they get cautious and then what could happen is

in a normal functioning economy normally we think about people save money you save money you put it in your bank account and then banks lend that money out to businesses who invest it and so usually there’s this balance between saving and investment but what if there’s a problem in the economy where people get they think that bad times are coming they start saving more preparing for the bad times and businesses aren’t going to borrow money and invest in bad times right if they think bad times are around the corner businesses aren’t gonna borrow that money so more and more savings builds up and sits idle and it’s not invested the second idea so this this can derail the economy because more people save less is spent businesses don’t pick up that saving and invest it the circular flow gets smaller and smaller second idea is of the multiplier effect now there are a lot of multiplier effects that people talk about the deposit multiplier the tax multiplier the government spending multiplier they all work in kind of a similar sort of fashion the multiplier says when when there’s when money drops into an economy somewhere it tends to get multiplied and so here I’m talking about say a government spending multiplier or a tax multiplier they’re kind of similar but some people have a different perspective on the two but let’s just suppose the government gives me an extra thousand dollars raised they to inject a thousand into the economy and they pick me and they give me a thousand dollars the marginal propensity to save is the proportion of each dollar that people will save on average so what will happen if I get a thousand that let’s suppose the marginal propensity to save for me and everybody else is about ten percent if I get a thousand that I’m gonna spend nine hundred and save a hundred dollars of it so my propensity to save is 10 percent is all we’re saying so I spend $900 suppose I give it to somebody to paint my house what’s the house painter gonna do well he’s gonna save ninety and spend a hundred and ten giving that to someone else suppose he spends it on a tune-up for his car the mechanic is gonna save 10% and spend the rest suppose he spends it on a doctor bill the doctors gonna save 10% and spend the rest if this multiplying effect keeps going to its logical conclusion throughout the economy then what effect is that original thousand dollars going to have on the economy well a simplified formula is to say one divided by the marginal propensity to save or one over that 10% equals ten so if we add up the thousand plus the nine hundred plus the eight ten plus the night 729 plus plus plus and we keep going to infinity the limit of all these different exchanges is going to be ten times a thousand or ten thousand dollars so that’s an idea of a multiplier we need to think about why well two reasons number one is when the government wants to make up for a the economy being too small and they want to spend more money well we need to know how much money to to spend right and what this what this multiplier tells us is that if the government wants to increase the GDP by ten thousand they don’t have to actually increase government spending by ten thousand they can do it with something less maybe a thousand in this case if this is if this is accurate okay the second reason is let’s think about this first idea let’s go back to the first idea that I was talking about this saving and investment behavior by consumers and businesses what will happen to this multiplier in cases where people are upset they think doom and gloom is going to come to the economy before the year 2000 a lot of people were talking about the y2k effect and that they were gonna have a Great Depression or a huge recession around the year 2000 because all the computers in the in the world are going to go berserk because they don’t know how to handle the year 2000 and their computer programming this was a big deal and what are you going to do as a consumer or a business if you think bad times are coming well when you get money you’re not going to spend it so what happens

during the bad times is this marginal propensity to save gets bigger maybe it gets as high as MPs equals 0.5 perhaps or maybe even higher maybe things get so bad that every dollar you get you save or every additional dollar so this doesn’t mean that every it wouldn’t mean that every dollar you save every dollar you have you save this is marginal means for each additional dollar you get how much of it do you save so it could be that each additional dollar you get you save all of it and so what that’s going to mean is as that marginal propensity to save gets bigger one over the marginal propensity to save gets smaller the multiplier gets smaller if it’s 0.5 1 over 0.5 is only 2 that would mean that the government if they spend a thousand that’s going to turn into two thousand dollars in additional spending in the economy not the ten thousand dollars we thought so what this points out is it becomes harder for the government to increase the impact of spending during hard times because generally the marginal propensity to save increases during hard times and it makes the the burden or the or the you know the job of the the government to try to fix an economy through spending even more difficult the third idea is that Keynes added is that look a classical economists thought that prices go up and down very easily in a market Keynes said no prices are sticky prices go up fast but then they get stuck they don’t go back down very fast and this seems to make some sense here that especially with wages that people don’t like for their wages to go down so part of the old classical model before the Great Depression was if people are unemployed they’ll just accept jobs for lower wages and the average wage will go down then more people will get hired and that’ll help fix the economy actually we usually don’t see people accept lower wages at least not very quickly things have to get pretty hard pretty bad for people to accept a lower wage so as I say here this is true prices will go down but it usually happens way too slowly to avoid a big long recession so when GDP Falls and people are out of work what can we do Keynes advocated that the government should just spend more to make up the difference replace consuming consumer and investment spending with government spending but again with fiscal policy they have two choices they can either spend more increase G or they can cut taxes to businesses and individuals and let them spend more so again this works sometimes but not other times let’s look at our aggregate demand aggregate supply model to try to tell us let’s let’s look and see what might happen here so erase some of this garbage from last time okay so suppose we find ourselves with high unemployment at a place something like this and people are very pessimistic what should we do well the government could spend more money and that will increase aggregate demand but again with the Lucas critique as that we talked about last time and so that so for two reasons the marginal propensity to save will go up when the government spends more money the Lucas critique number one says when the government spends more especially when it spends more and it borrows the money to spend people are just gonna turn around and save more because they know they’re gonna have to pay this money back at some point some people believe this some people don’t and secondly because times are hard people are gonna save more so just because times are hard and people are pessimistic so pessimism people are going to save more so for both of these regions reasons the marginal propensity to save is going to go up the multiplier is going to go down and that’s going to mean that in order to get aggregate demand to get go higher the government might not have to spend a whole lot of money a whole lot of money to do that or cut taxes a whole lot of money to do that now what if your government has already

already has too much debt well this adds other problems you know maybe the government can’t borrow anymore without losing their their credit rating or without increasing their interest rate on their existing debt and so if you’re already trapped in a debt spiral maybe government spending is not the thing to do and so this is why a lot of people say maybe we should let the Federal Reserve do it one additional reason why why fiscal policy is pay or when one thing that makes it I won’t say it’s bad but one thing that makes fiscal policy harder is it takes a lot more time to implement fiscal policy than monetary policy you know think about in the United States in order to spit for the government to spend more money or cut taxes a bill has to be originated in the House of Representatives it has to be passed it has to go to the Senate who has to pass it but they always pass a different version then the Senate and the house have to get in conference and merge the two bills together then they have to vote again to pass it and then the president has to sign it into law and then it has to actually be implemented and this can take a long time years so monetary policy most people think is a little bit better way to do it where we get aggregate demand increased by the Federal Reserve creating new money by buying bonds so they buy bonds this increases the money supply and when you increase the money supply interest rates go down so interest rates go down and the interest rate that the Federal Federal Reserve focuses most on is a short-term interest rate called the Fed Funds rate Fed Funds rate the Fed Funds rate is an overnight short-term rate that is between banks so Wachovia Bank and Bank of America if they loan each other money overnight for a short period of time that’s what we’re calling the feds that’s called the Fed Funds rate it’s not actually a loan from the Federal Reserve which we call the Fed so it’s kind of a confusing name Fed Funds and so if they buy bonds there’s more money in the economy banks have more money to lend that pushes the interest rate down when the interest rate goes down more people are more likely to buy more a to borrow more money and when they borrow more money to buy houses and cars or businesses borrow money to build a new factory then the economy will get going but wait what about the elephant in the room didn’t we just say that when times are bad the marginal propensity to save will increase so if we lower interest rates when people are trying to save more not borrow more because they’re pessimistic and businesses are pessimistic they don’t want to build new factories in bad times sometimes what we see is that monetary monetary policy doesn’t really have a lot of effect and this is one of the problems that Japan has been in for years they have the Japanese government has been trying to stimulate aggregate demand in a lot of different ways but they haven’t been able to and in the United States this recession we’re in now started in some time in 2008 and the Federal Reserve has had interest rates near zero for many many years now and our economic growth yeah two percent not fast enough to really get the aggregate demand back up to where we want it to be all we’re doing now with it with a growth rate of 2% here’s here’s a here’s a graphical depiction of what’s going on in the United States right now in my mind we have relatively high unemployment and with with a growth rate of 2% in the economy and unemployment rates going going down very very very slowly here’s kind of what I see going on let me draw I’ll use green yeah I want to pick a different color that I haven’t used let me use orange here here’s what I see going on in the economy right now we have we do have aggregate demand recovering as people start to get more jobs and the government is still spending money like crazy and the Federal Reserve is still keeping interest rates low aggregate demand is

increasing but also aggregate supply is increasing so I didn’t go through what causes aggregate supply to increase but let’s let’s talk about that now let’s look at these factors so the aggregate supply curve can actually shift if we think about these determinants so what are the other things Visayas price level that can cause changes in GDP related to supply a change in input prices could be affected by availability of resources land labor capital and entrepreneurial ability so if all of a sudden we allow more people into the country say who have PhDs or have other sorts of resources or if we allow allow more imports of steel and oil and other sorts of productive factors without tariffs then this could shift aggregate supply the price of imported resources so we reduced tariffs negotiate a free trade agreement for example if we bust up monopolies and make those businesses more competitive that could shift aggregate supply also anything that changes productivity so productivity is just real output over the amount of inputs usually we think about how much output we get per hour of Labor is a common way to do this for productivity real real output per hour worked so more machinery more technology more inventions better technology better trained workers can increase the aggregate supply curve because we’re increasing potential GDP other things are the chain changes in the legal environment which could be related to business taxes if we make the tax system fairer easier to use we change the tax structure to give people more incentive to become entrepreneurs and open businesses that can increase accurate aggregate supply we loosen government regulations appropriately to make it easier to start businesses this something we watch in various countries to see how many hours does it take to get a permit to open a new business in a country in some countries it’s just one or two hours in some countries it can be years also protection of property rights the the less protection of property rights you have means fewer businesses will be in the market instead of equals maybe we should have implies there fewer businesses will be in the market and a lower aggregate supply why would I start a business if I’m in a country where the government can just take that business from me or shut me down for absolutely no reason so protection of property rights better protection of property rights can increase aggregate supply so let’s go back and look at our look at our graph here so what I see happening in in the United States right now is even though aggregate demand is increasing aggregate supply is increasing a little bit as well and so and not necessary in unemployment due to this but not at the rate that we want not really at the rate that we want so we are increasing aggregate demand a little bit here look my computer is starting to go crazy here I think I have drawn too many lines on it for the amount of memory it has but in any case let me wrap up the video now before we we crash and go bye-bye here but basically in the United States every year in in every country aggregate supply and aggregate demand or both shifting and so when aggregate supply is increasing that increases the potential GDP and if aggregate demand is not moving fast enough to catch up to it then that means that we’re not really making a lot of progress in catching up to that full level of GDP even though we might have growth in the country we might not see unemployment approaching that natural rate of unemployment yes yet so I’ll make a couple of other videos with other little details later but this this gives you most of the framework for aggregate demand and aggregate supply that you need in order to understand what’s going on and so if you have questions as always please let me know in the comment section below but please don’t comment on my bad handwriting thanks

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