In the last two videos, we've been slowly
building up our aggregate demand-aggregate supply
model and the whole point of us doing this
is so that we can give
an explanation of why we have these
short run economic cycles and we don't just have
this nice steady march of economic growth due to
population increases and productivity improvement.
It's important to realize and it's probably
important to realize this for all of what we study
in micro and macro economics that this is really
just a model.
In order for to use these models, we have to
make huge, huge simplifications and you really
should always view these models with a
This is just one way to view it.
You might not agree with it.
You might think it's an over simplification.
You might want to modify it in some way.
It's very important that you just view it only
as a model and the reason why we do that is so
that we can start to describe very, very, very
complicated things with fairly simple graphs
and mathematics so that we can get our brain
around something as complicated as the economy.
Something that has hundreds of millions of actors,
each of them with tens of billions of neurons
in their brain and doing all sorts of crazy things.
We're able to distill it down to simple lines
and curves and equations.
Now in the last video, we looked a little bit at
the long run aggregate supply.
Aggregate supply in the long run.
In the ADAS model, we assumed that in the long run,
the real productivity of the economy really
doesn't depend on price, that price is really just
a numeric thing and in the long run, people will
just adjust to producing or the economy will
just adjust to producing what it's capable of
Now there's one thing I want to stress here.
This is not the maximum productivity of the economy.
You could view this as the natural;
let me put it this way.
You could view this as the, so this right over here,
you could view it as the natural output.
Natural, the natural real output of the economy.
When I say natural, it means that there's
always going to be some inefficiencies in the
economy; people are going to be switching jobs.
They might have to retrain.
There's always going to be turnover in things.
Some people pass away in a job and then they
have to hire other people.
There's some normal or natural rate of
In most economies, people aren't working
night and day.
They want to take some time off.
They want to be able to rest.
Because of other interventions, there aren't
perfect efficiencies in the economy as a whole.
This is just a natural healthy level of output.
There is some theoretical level of output.
I'll draw that here.
This is maybe some theoretical level of output
that you could maybe view as maximum output.
Maybe I'll draw it right over here.
This right over here might be maximum output.
Maximum, given the population and the
technology that the population has,
this is some type of theoretical thing and it
would be very hard to actually quantify.
People were just working all out.
They weren't taking vacations.
They weren't sleeping properly.
Every person was working in the place that
they could be the most productive, then maybe
you would have some output over here which is
kind of impossible to achieve.
This is something below that, kind of a nice
healthy level of output for the economy.
Now what we're going to talk about in this video
is aggregate supply in the short run and what
we're going to see is for this model to work,
for the aggregate demand-aggregate supply model
to work, we have to assume an upward sloping
aggregate supply curve in the short run.
It might look something like this.
It might look something like this and obviously,
it would; actually let me do it this way.
Let's assume that this is our current level of
prices are sitting right over here.
This is our long run aggregate supply.
It's not depending on prices; it's just a natural
level of output, but in the short run it might
look something like this.
I'll do it in pink.
In the short run, it might look something like this.
As I'm toting it up because obviously we can
never get past that optimal, so what's going on
here, what's going on in this curve -
I drew a dotted line because it's easier for me to
draw something as a dotted line when I draw
it as a straight curve. My hand always shakes too
much - so this is the aggregate supply in the
We'll see we need it to be upward sloping for
this model to provide a basis of explanation
for economic cycles and there's a couple of
explanations or a couple of, you could really
view them as theories, for why we can justify
an upward sloping aggregate supply curve.
The one way to think about it and before I even
justify why it could be upward sloping, what an
upward sloping curve is saying is look, this is
just when people are nicely ... They're producing
at their natural rate.
There's going to be some unemployment in the
economy at this level right over here.
For whatever reason, this upward curve is saying
if prices go up, if prices go up, then the
economy as a whole is going to produce beyond
that natural rate.
Maybe it's going to bring in people from other
parts or I guess you could say it's going to
suck people in to the labor pool who might not
have been in the labor pool to work a little
Maybe they feel they can do a little bit better now.
It might convince factories to run a little bit
It might convince people to take fewer vacations.
The opposite might be true if prices go down.
An upward sloping curve is saying that if prices,
aggregate prices - Now this isn't just prices
in one good or service - if aggregate price is
going down, it's saying in the economy as a whole
people might be incented to work a little bit less.
People might drop out of the labor pool.
In the short run, remember this is all in the
short run, they might drop out of the labor pool.
They might not run their factories all out.
They might take more vacations, whatever else.
Now let's think about what our plausible
justifications for an upward sloping aggregate
The first one is often called the misperception
theory; let me write it in white.
It's the misperception theory and it kind of makes
sense to me that if the aggregate; let's think
about a situation where the aggregate prices are
Aggregate prices are going up.
If I'm an individual actor there, maybe I run
a firm of some kind, I might not notice immediately
that it's aggregate prices that are going up.
I might just think that prices for my goods or
services are going up.
I might think that it's actually a micro
economic phenomenon going on.
I'm misperceiving it as a micro phenomenon.
That's something that's going on in my market.
If I think and this goes back to the micro economics,
if I think that prices for my goods and services are
going up relative to others and remember
this is a misperception,
all prices are going up, but if I think this is
happening in the short run then the law of
supply kicks in.
Then the law of supply kicks in which is a
micro economic concept that if I feel that
real prices - And it's not real prices. It's
actually nominal prices - but if I think my
relative prices are increasing, I'm motivated
to produce more.
I think I'm going to be more profitable.
It only takes a little bit of time for me to
realize that all my costs are going up,
what I can purchase with my profits are all
In real terms, I'm actually not getting any better
and then I'll probably settle in back to my
regular level of productivity.
While I think people are demanding more of Sal's
sprockets or whatever I'm seeing, I'll start
working over time.
I might want to hire more people, run the factories
beyond even a level that I might defer maintenance
so that I can run the factories longer and all
the rest, but then over time I'm going to realize
that I was just misperceiving things.
Everything has gotten more expensive.
I'm not making in real terms an outsized profit
Then my level of productivity might actually go back.
When I talk about me, it's not me by myself
that's moving this whole economy.
Remember I'm just talking about one actor, but this
might be true of many, many, many actors in
acting in aggregate so as a whole, they might
want to increase productivity and then when they
realize that in real terms they're actually not
making any more money and that this isn't
sustainable, they'll go back to their natural
level of output.
The other theory that you'll read about in
economic textbooks, another theory or explanation
or justification why we would have an upward
sloping aggregate supply curve in the short run
is sometimes it's called the sticky wages theory.
I like to extend it to sticky cost theory.
Sometimes they'll articulate a separate one
called sticky prices, but in my mind these are
all very similar, so sticky wages, sticky costs and
Sticky, sticky prices.
It's the general idea that even if in aggregate
prices are increasing, so in the whole economy
prices are increasing, in all parts of the economy
they all won't increase at the same rate.
There are parts of the economy
where the prices might be stickier than other
places and there's multiple reasons why
prices could be sticky.
You could have wage contracts or people might
just be slow to realize prices are going up
and then renegotiating their contracts.
You might have long term agreements with suppliers
that you're going to pay a fixed price over
some period of time.
You've already agreed for the next year
to pay it so even if aggregate prices
are going up, it's going to take a while in
different parts of the economy, for contracts
or for transactions in those parts of the economy,
to actually reflect those things.
Another reason why in parts of the economy you
might not have everything move in tandem or
everything move as quickly as you would expect
is because of something called menu costs.
Menu costs are just the idea that if prices are
changing, if prices move up in the next hour 5%,
it's not actually trivial to increase your
prices by 5%.
For example, if you were running a restaurant,
you would have to reprint new menus, so that's
where the name comes from, but it's not just true
of a restaurant; it's true of anything.
It would be true if you're any type of supplier.
You would have to change your brochures.
You might have to change your computer systems.
You have to do a ton of things to actually make
things; you have to tell your sales force
how the pricing might be different.
There's a ton of things that you have to do to
actually change costs.
These menu costs actually might slow down the
ability for all prices to move in tandem.
Some of them will be stickier than others and
the reason why this is can be a rationale
for an upward sloping aggregate supply curve
in the short run is if I'm in one of these
industries, let's say my sales I am able to
raise the prices but let's say the wages and my
costs are sticky.
I've already got into a long term wage contract
and all my suppliers can't raise their prices
as fast, so in the short run I'm going to say gee,
I'm making a lot of profit now.
Even in real terms because my costs are being
relatively sticky, while the money that's coming
in the door I'm able to raise the prices so
I'm going to produce more.
I'm going to run the factories longer.
Maybe I'll defer maintenance so that I can
Maybe I'll try to hire more people under these
Maybe I'll try to buy more goods and services
under these long term costs.
The reason why I say these are really the same
side of the same coin is you can imagine here
you have company A that is able to increase
its prices so its revenue starts going up and
let's say its supplier is company B.
It's company B and this right over here is sticky.
This is sticky.
Maybe A buys lemons from B and then sells
It's able to raise the price of lemonade,
but it has a fixed price contract on the lemons
in the short run.
Eventually that will expire, in the long run B will
be able to renegotiate it upwards.
A's costs are sticky, but this is B's
prices are sticky.
These are really the same thing that one's costs
are really the other's prices.