Demand and Supply Shocks in the AD-AS Model

Summary

The video script discusses the economic concepts of demand and supply shocks, explaining how they impact a country's economy in the short run. It begins with defining positive demand shocks, which occur when there's an increase in aggregate demand (AD) due to higher consumption, investment, government spending, or net exports. This leads to demand pull inflation, where a higher price level incentivizes businesses to produce more, leading to a new short-run equilibrium with increased output and average price level. Negative demand shocks, on the other hand, result from decreased AD, causing deflation or disinflation and a new equilibrium with lower output. The script then explores aggregate supply shocks, with negative supply shocks causing cost-push inflation due to increased production costs, and positive supply shocks leading to deflation or disinflation as production costs fall. The video concludes with the implication of these shocks on economic growth and price stability, setting the stage for a discussion on long-run adjustments in the next video.

Takeaways

• 📈 **Positive Demand Shock**: An increase in aggregate demand (AD) from factors like higher consumption, investment, government spending, or net exports can lead to a temporary economic boom and demand-pull inflation.
• 📉 **Negative Demand Shock**: A decrease in AD due to factors like rising interest rates leading to less investment can result in deflation or disinflation and a recessionary gap, indicating a shortfall in demand.
• 💰 **Household Wealth Impact**: An increase in household wealth, such as from rising home prices, can boost consumption and consequently aggregate demand, affecting the economy's short-run equilibrium.
• 🛍️ **Consumption Effect**: Higher consumption at every price level due to increased wealth can outstrip supply, leading to a goods and services shortage and subsequent price adjustments.
• 🔥 **Demand Pull Inflation**: An increase in the price level stemming from unmet increased demand, without a corresponding output increase, can lead to inflation.
• 🛠️ **Supply Shocks**: Unexpected increases in production costs, like energy prices, can cause an inward shift in the short-run aggregate supply (SRAS) curve, leading to cost-push inflation.
• 📊 **Cost-Push Inflation**: When production costs rise, it can result in higher prices and a decrease in national output, even if demand remains stable, indicating a supply-side issue.
• 🚫 **Regulation Impact**: Deregulation or policies that reduce production costs can increase aggregate supply, potentially leading to lower prices and economic growth.
• 📉 **Deflation or Disinflation**: A positive supply shock, such as deregulation, can cause prices to fall (deflation) or inflation rates to decrease (disinflation), increasing the equilibrium level of national output.
• ⚖️ **Equilibrium Adjustments**: Disequilibrium in the market, whether due to demand or supply shocks, necessitates price level adjustments to achieve a new short-run equilibrium.
• 🌐 **Economic Growth Scenario**: An increase in short-run aggregate supply, rather than demand, is the most favorable scenario for a country's economy as it indicates growth with price stability.

Q & A

What is a positive demand shock and what causes it?

A positive demand shock occurs when there's an increase in aggregate demand (AD), typically resulting from increased national expenditures such as consumption, investment, government spending, or net exports. An example provided is an increase in household wealth leading to increased consumption.

How does a positive demand shock affect the economy in the short run?

In the short run, a positive demand shock leads to an increase in output and price levels. Initially, it causes a disequilibrium where the quantity of output demanded exceeds the quantity of output supplied, leading to a shortage. This prompts an increase in prices (demand-pull inflation) and a new equilibrium at a higher output level.

What is a negative demand shock and its implications?

A negative demand shock occurs due to a decrease in aggregate demand, caused by reduced consumption, investment, government spending, or net exports. An example is a rise in interest rates reducing private sector investment. This leads to a surplus of goods and services, requiring a fall in prices (deflation or disinflation) and a decrease in national output, resulting in a recessionary gap.

What are aggregate supply shocks and their types?

Aggregate supply shocks are unexpected events that change the costs of production, thus impacting the short-run aggregate supply (SRAS). There are two types: negative supply shocks, which increase production costs and decrease SRAS; and positive supply shocks, which decrease production costs and increase SRAS.

How does a negative supply shock affect the economy?

A negative supply shock, such as a rise in energy prices, increases production costs and decreases the quantity of goods supplied. This leads to higher prices (cost-push inflation) and a reduction in output, creating a recessionary gap even though the demand remains unchanged.

What results from a positive supply shock?

A positive supply shock, such as a massive deregulation, reduces the costs of production, leading to an increase in SRAS. If the price level remains unchanged, it creates a surplus, driving prices down. This leads to deflation or disinflation and an increase in the equilibrium level of national output, indicating economic growth.

How does deflation differ from disinflation?

Deflation refers to a fall in the general price level of goods and services, while disinflation refers to a decrease in the rate of inflation. Disinflation occurs when prices are still increasing but at a slower rate than before.

What is demand-pull inflation and what causes it?

Demand-pull inflation is an increase in the price level resulting from an increase in aggregate demand. It typically occurs when the economy experiences a positive demand shock, leading to higher output and increased prices due to the demand exceeding the current supply.

What is cost-push inflation and its primary cause?

Cost-push inflation occurs when rising production costs, due to negative supply shocks, lead to higher prices, independent of demand changes. This inflation type reduces the economy's output and increases prices because the costs of producing goods have increased.

What are the economic implications of a recessionary gap?

A recessionary gap is characterized by the actual output being less than the potential output at full employment. It typically results from negative demand or supply shocks and leads to higher unemployment, lower income, and reduced economic growth.

Outlines

00:00

📈 Positive and Negative Demand Shocks

This paragraph discusses the concept of demand shocks, which are changes in aggregate demand (AD) that can cause output gaps. A positive demand shock occurs with an increase in AD from factors like higher consumption, investment, government spending, or net exports. This leads to a new short-run equilibrium with higher output and price levels, known as demand pull inflation. Conversely, a negative demand shock results from a decrease in AD, causing deflation or disinflation and a recessionary gap as the economy adjusts to a lower output level.

05:01

📉 Aggregate Supply Shocks: Positive and Negative

The second paragraph delves into aggregate supply shocks, which are disruptions to the production costs that affect a country's short-run aggregate supply (SRAS). A negative supply shock, such as a rise in energy prices, results in cost-push inflation, characterized by higher prices and a decrease in national output, leading to a recessionary gap. On the other hand, a positive supply shock, possibly due to deregulation, increases aggregate supply, potentially causing deflation or disinflation and an increase in national output, indicating economic growth and price stability.

10:01

🌱 Economic Growth and Long-Run Adjustments

The final paragraph briefly touches on the most favorable scenario of increased short-run aggregate supply, which signifies economic growth and stable price levels. It sets the stage for the next video, which will explore long-run adjustments to a country's aggregate output in the aggregate demand and aggregate supply (AD-AS) model, suggesting a deeper analysis of how economies adapt over time to various shocks.

Keywords

💡Short-run equilibrium

Short-run equilibrium refers to a temporary state in an economy where aggregate demand and aggregate supply are balanced, but not necessarily at full employment or potential output. In the video, it is used to set the context for discussing how economies can deviate from this equilibrium due to various shocks.

💡Output gaps

Output gaps are the differences between an economy's actual output and its potential output. Positive output gaps indicate the economy is producing more than its potential, while negative output gaps suggest it is producing less. The video explores how demand and supply shocks can lead to these gaps.

💡Aggregate demand (AD)

Aggregate demand is the total demand for the goods and services produced in an economy. It is comprised of consumption, investment, government spending, and net exports. The video discusses how changes in AD can lead to either demand pull inflation or deflation.

💡Aggregate supply (AS)

Aggregate supply represents the total supply of goods and services that firms in an economy are willing and able to produce at different price levels. The video explains how shocks to aggregate supply, such as cost increases, can lead to cost-push inflation or disinflation.

💡Demand shocks

Demand shocks are changes in aggregate demand that can be either positive or negative. A positive demand shock, such as increased consumption due to rising home prices, leads to demand pull inflation. Conversely, a negative demand shock, like reduced investment due to higher interest rates, can cause deflation or disinflation.

💡Supply shocks

Supply shocks are unexpected events that affect the cost of production and, consequently, aggregate supply. An example given in the video is an increase in energy prices, which leads to cost-push inflation. Positive supply shocks, on the other hand, can result in disinflation or deflation.

💡Demand pull inflation

Demand pull inflation occurs when aggregate demand increases, leading to a higher price level and a new equilibrium where businesses produce more, and households demand less. The video illustrates this with the example of increased household consumption due to rising wealth.

💡Cost-push inflation

Cost-push inflation happens when there is an increase in the costs of production, which decreases aggregate supply and leads to a higher price level. In the video, it is exemplified by an unexpected rise in energy prices, causing businesses to supply less, and thus, leading to inflation.

💡Disinflation

Disinflation is a decrease in the rate of inflation. The video describes how a negative demand shock can lead to disinflation, where prices do not necessarily fall, but the rate at which they increase slows down.

💡Recessionary gap

A recessionary gap is a situation where the actual output of an economy is below its potential output. The video mentions that negative demand shocks and negative supply shocks can both lead to recessionary gaps, indicating a shortfall in demand or supply, respectively.

💡Economic growth

Economic growth is the increase in the production of goods and services in an economy over time. The video suggests that a positive supply shock, such as deregulation, can lead to economic growth by reducing production costs and increasing output.

Highlights

Positive and negative output gaps can occur due to shocks to aggregate demand and aggregate supply.

Positive demand shocks occur when there is an increase in consumption, investment, government spending, or net exports.

An increase in aggregate demand can lead to a disequilibrium in the short run, resulting in a shortage of goods and services.

Demand pull inflation is a rise in the price level resulting from an increase in aggregate demand.

A new equilibrium is achieved at a higher price level, which incentivizes businesses to increase output.

Negative demand shocks cause deflation or a decrease in the inflation rate, leading to a decrease in national output.

A decrease in aggregate demand can result in a surplus of goods and services, causing a new equilibrium at a lower price level.

Negative supply shocks occur when there is an increase in the costs of production, leading to a decrease in short-run aggregate supply.

Cost-push inflation is caused by an increase in production costs and a decrease in aggregate supply, resulting in higher prices and a recessionary gap.

Positive supply shocks, such as deregulation, can increase aggregate supply and lead to deflation or disinflation.

An increase in aggregate supply can lead to economic growth, increased output, and price level stability.

The video discusses four different economic scenarios: positive demand shock, negative demand shock, negative supply shock, and positive supply shock.

In the next video, the focus will be on long-run adjustments to a country's aggregate output in the AD-AS model.

The equilibrium price level and quantity of output adjust in response to demand and supply shocks.

Households' decision to consume more due to rising wealth can increase aggregate demand.

Rising interest rates can decrease private sector investment, leading to a negative demand shock.

Unexpected increases in energy prices can cause a negative aggregate supply shock, shifting the short-run aggregate supply curve inward.

Deregulation can lead to a positive supply shock by reducing production costs and increasing the desire to produce more output.

Transcripts

in our last video we talked about the

states of short-run equilibrium that a

country's economy could experience we

showed in a das 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 going

to 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 a D or a s

let's start with the definition of

demand shocks will actually define

positive demand shocks first and then

we'll show the effect that that 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 of

this will have in the short run in our a

das 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 a d1 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 in 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 this case so demand Paul

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 pl - 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 srs 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 a

greedy demand increases that of course

means that a negative demand Katoch 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 PL II well there would be

once again a disequilibrium the quantity

of output demanded we'll call that Y D

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 in the government and foreigners

and a decrease in the quantity of output

supplied by the nation's producers as

the price level Falls we're going to see

a new equilibrium at pl2 and a new

equilibrium level of output at Y E 1 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 on the

inflation rate which is known as dis

inflation 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 all right let's move on and talk

about aggregate supply shocks this time

we're going to 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 PL e 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 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 SR as1

assume once again that the price level

remains at its original level of PL e if

the price level did not fall following

the increase in aggregate supply we

would have a quantity of output supplied

that's why s 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 in foreigners will demand a

greater quantity of output and will

achieve a new equilibrium

so this is the new equilibrium call that

PL - 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 the 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

costs of production in the 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 costs 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

shortened 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 going to talk about long-run

adjustments to a country's aggregate

output in the a das model

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