Source: Image of Business Cycle created by Kate Eskra, Image of Aggregate Demand created by Kate Eskra, Image of SRAS created by Kate Eskra, Image of LRAS created by Kate Eskra, Images of AD/AS model created by Kate Eskra
Hi. Welcome to macroeconomics. This is Kate. This tutorial is on business cycles, aggregate demand and aggregate supply. As always, my key terms are in red, and examples are in green. So in this tutorial, we'll be comparing the business cycle with our ADAS model, and you'll see three situations on both of these models-- the economy in long run equilibrium, in a recessionary period, and in an expansionary period. Finally, we'll talk about how it's possible for the economy to actually self correct sometimes through changes in the price level. OK.
So you've seen this. This is a business cycle. And we know that it's normal for our economy to go through periods of growth and contraction. If we put this grey line on here, that shows us that over time, GDP tends to grow. So that's what this is, our overall growth trend. So there are times we know that it's growing quickly, and times that it is shrinking.
We can see these periods of growth and contraction in much more detail when we use our aggregate demand and aggregate supply model. So as a reminder, let's go through the components of this model. Aggregate demand, as you'll recall, are all the goods and services demanded in the economy at a point in time and at a prevailing price level. So here's what our aggregate demand curve looked like. It's a downward sloping curve, showing that people-- the consumers, firms, governments, and foreign purchases of US goods-- people want to purchase more as the overall price level falls. And we've gone through that. It's because the three different effects-- the wealth, interest rate and exchange rate effects.
Short run aggregate supply is going to have a positive price and quantity correlation, showing that more can be produced in the short run by increased resource utilization, technological improvements, or other factors. And so that's what short run aggregate supply looks like. In the short run, businesses can actually produce more as prices go up, because they won't have to pay their workers more immediately. They can use inventories that they already have. And so it can slope upwards in the short run. If we put these two together, you see that we get an equilibrium here.
So the intersection at equilibrium will give us our real GDP and our prevailing price level. But now we have to add in our long run aggregate supply. Recall that long run aggregate supply is going to be constant in the long run, because in the long run, resources are assumed to be used optimally. And if we're at our long run aggregate supply curve, you'll see that there's no potential for increasing capacity. And so it's going to be a vertical line like this. This shows our economy's full potential in terms of production given our current resources.
So in the short run, we can only ramp up our production so much. It can only get us so far, because we really do have a limited amount of resources. So think of this curve as our economy producing as much as possible given what we have right now today. So if we put these three things together, you'll see that the way I drew this one is, our economy is currently producing-- that's where the intersection of short run aggregate supply and aggregate demand-- it's currently producing where long run aggregate supply intersects as well.
So that would mean that currently our economy is fully employed, and we're producing the maximum amount possible given our current resources. One thing I just want to point out is that when we move along this x-axis here, if we are moving this way to the right, that would mean that GDP is increasing. That would also imply that unemployment rates are falling.
If we're moving this way, to the left, that would mean that unemployment is increasing. OK? That's going to be important in a couple of slides. So if we want to compare this to the business cycle, we put that growth trend on there. The long run aggregate supply curve is actually similar to this overall growth trend that I drew here in gray.
When the economy is producing in equilibrium, we're right on our growth trend in the business cycle. We're producing exactly a sustainable quantity with our resources. OK? So this model doesn't really have price level or anything on it, whereas this one does. This is giving us a snapshot of a point in time. So we're really, the idea we're on this growth trend, if, in fact, we're producing at our long run aggregate supply curve.
Now during a recession is different. So note that I drew this one with our economy currently producing at a real GDP less than our long run aggregate supply. So that means our unemployment rate has risen. We are not fully employed. We're producing less than our full potential. We can see this actually on the business cycle. We'll be below the growth trend here. OK? We're somewhere either near a trough, or at least below the growth trend. And what we can do is compare the distance horizontally, on this graph, with the vertical distance on this graph. OK? So as much as unemployment has increased, that would be the vertical distance here.
So a trough, remember, is the business cycle period that coincides with the lowest GDP for a given point in time. Now let's look at an expansion. In an expansionary period, our economy is actually currently producing beyond our long run aggregate supply. And so on the business cycle, we're producing above our growth trend. We can see that, again, the horizontal difference here is the same as the vertical difference here. So remember, how is that possible? Well, let's remember that a peak is the business cycle period that coincides with the maximum obtainable GDP for a given point in time.
And when we're at an unsustainable price or output combination at a peak, this is what's going on. It is possible in the very short run, because we can move beyond that. But let's look at what's going to happen. Because demand has risen, prices are going to rise. Consumers are willing to pay more. Producers now want to produce more, and they can, by drawing down their inventories and using resources faster than they're being replaced. But that's not sustainable. That's why our long run aggregate supply curve is here.
So once inventories are depleted, and producers need to order more, now there are going to be shortages at those previous prices, and the prices of inputs will start to rise. And that is going to shift our short run aggregate supply curve to the left. As input prices go up, SRAS shifts to the left and brings us right back to our long run aggregate supply.
So let's run through an example. This is a very simplified example, but let's talk about the housing boom that occurred in the early 2000s. There was a huge increase in demand that I represented here with that new aggregate demand curve. So now prices are rising, you can see that. Because prices are rising, builders want to respond. They're going to try to build more, and more, and more. And they did. But at some point, their costs began to go up, because there's only so much that can be produced in a given time frame. And so let's say just one thing, the cost of lumber, starts to go up.
It is actually possible for the market to self correct. So now that we have these increased costs of productions, like I said, short run aggregate supply curve can shift to the left, because builders have to charge higher prices for homes. We move right back to our sustainable long run aggregate supply level of real GDP. The market has essentially corrected itself through changes in the price level. But keep in mind, although we're back at the sustainable level of real GDP, notice that prices have significantly risen from where they were here.
Now does this occur when we're in a recession? So will this same self correction occur? So here, I've shown that we are in a trough, or in a recession. So in theory, since inventories are starting to build up due to low demand, suppliers might start to lower prices. If they did, that would allow SRAS to shift to the right. Workers might, in theory again, even be willing to work for less, as unemployment is really high during a recession. If in fact prices do fall, then the market can naturally correct, bringing the economy back to full employment. But this isn't as common as we saw with the opposite, in an expansionary.
So if it doesn't occur, if prices do not adjust downward., then we could be stuck here. And we find, actually, that prices don't always adjust downward. When suppliers are reluctant to lower prices, as they commonly are, prices are said to be sticky. And in this case, the economy could actually be stuck in a recession indefinitely. And for that reason, often that's why we see the government or our Federal Reserve System try to intervene to try to increase aggregate demand to get us back to full employment.
So if that had happened, it could take us there. But more often than not, that doesn't happen because prices can be sticky. And sticky prices refer to prices that don't easily move below the threshold value, even though theory would anticipate a decline to reestablish our market equilibrium.
So here's everything that we went over in this tutorial. We compared our business cycle with our AD/AS model. And we finally just talked about how it's possible for the economy to self correct through changes in the price level. But when prices are sticky, this doesn't happen, and we might need government or Fed intervention.
Thanks so much. Have a great day.