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Video transcript

let's make a plot of real GDP as a function of time so this axis right over here is going to be real GDP so it's an actual measure not just nominal GDP it's an actual measure of the goods and services produced by an economy or the productivity of an economy and over here let's have time now in our little country or whatever economy we're studying here let's assume that over time its population is growing so let me write these things down so population population is growing over time the pot and this is not an unrealistic assumption this is true of most countries population is growing over time and also let's assume that productivity is improving productivity productivity and productivity is just essentially how much can each individual person produce productivity productivity is going up and productivity goes up due to technology in fact probably mainly technology technology mainly technology but there could be discoveries of resources discovery of resources or it could be new business processes and people would even consider that maybe technology so new new processes so on a per person basis they're able to produce more and more overtime so because of these trends and these are trends that do take place over long periods of time in many many economies you would expect the real productivity of that economy to increase so if you were just do the long term trend just based on these two things the population growing in productivity improving over time real GDP should have a trend something like that and that is the long term trend of most properly functioning economies but when you look at it on the short-term it doesn't look like a nice smooth trend line like this when you study any major economy they're all really any economy any normal economy instead of just going this nice smooth trend line it tends to look something more like this real GDP real GDP will be going really fast maybe it higher than the trend line and then all of a sudden it will it will essentially recede or essentially shrink and then it'll start growing again maybe go above the trend line then oversee go below the trend line then go above the trend line it'll just keep fluctuating it'll keep fluctuating around a trendline like that and this fluctuation around this trend line this is called the business cycle this right over here and you could maybe call one cycle you could say it's from one peak to one peak or one trough to one trough or whatnot whatever you want to call it it's this idea that that the economy isn't just a nice steady you know steady as you go growth you have periods of fast growth going above maybe the trend line and then it recedes then it expands then it recedes and so this is the business cycle business cycle and the term cycle is a little bit misleading whenever you do think of a cycle and even the way I drew it it kind of looks like a nice well-defined pattern and you know every every the same amount of years you're going up and down it kind of implies that it's predictable but the reality is that the business cycle is very unpredictable and economists more than anyone have trouble predicting the business cycle so when you think of a cyclist not this well you know it's not this nice sinusoidal it's something much much more unpredictable so it does fluctuate up and down above a trend but it's hard to predict hard to predict and in general you don't have the same period of time between every peak in every trough and that's why it is so hard to predict and we end there that there are different terms for different phases of the business cycle and I kind of used it just in describing what was happening over here where the economy is growing so the economy is growing from there to there from there to there we would call this phase of the business cycle so I'll highlighted that in green we would call that expansion because the economy is literally expanding there's more goods and services being produced in that economy and then when and we'll talk about the reasons why this is happening and then all of a sudden when it starts to shrink the economy starts to shrink this right over here or you could call it recedes you know if you think of it in kind of a title analogy this right over here is called a recession this right over here is a so that purple part right over there is a recession and if a recession is bad enough and is sometimes categorized as a depression and there's different categories for a depression there's the famous joke when your neighbor loses you're his job it's a recession when you lose your job it is a depression but the interesting thing is is we see this pattern happening every you know whether it's every eight years seven years every ten years but we don't fully understand exactly why it's happening and what we're going to try to attempt to do in the next few videos is look at models that do attempt to explain it and that's actually the whole purpose why we're going to study aggregate demand and aggregate supply now with that said I want you to view those models with a huge grain of salt because those are I would argue overly simplified economic models that don't take into consideration probably the most important factor in the economic cycle or any type of market cycle and that is human emotions human human emotions you might notice in most of our studies of economics so far we haven't really talked a lot about human emotions or humans tendencies to extrapolate the recent past or humans greed or risk of rigged fear and greed and all of these things that are very real things because in traditional economics they don't fit neatly into the models and there are there are new fields in behavioral economics and behavioral finance that do try to take into account things like human emotions but it's not going to make its way into the models that we're going to study for in aggregate so an aggregate supply and aggregate demand and the reason why I say human emotions is because that you know just based on I spent oh I think was six or seven years in in market so I was an analyst at an investment firm it was very clear to me that what drove market cycles and economic cycles to a large degree was based on human emotions that what you have happening over here is that the further the more the longer time and this is once again this isn't kind of what you would classically learn in your freshman economics class I'm just going to say this before we start studying the classical one because I think this does give a better sense of what's probably happening in an economic cycle right over here when the expansion's phase is starting people are still skeptical they've just been through this this you know people were getting laid off over here people were losing their jobs people were having trouble paying the bills companies were had very low profits or maybe no profits at all bankruptcies were occurring so even though the economy is starting to expand right over here people are kind of skeptical in the recent past they remember all of this pain so they don't want to go out there and start spending money they don't want to go out there and start investing but the further and further they go from that point an Islamic just explained kind of the emotional aspect of the economic cycle which i think is probably the most powerful one the further and further they go away from they say hey maybe this is for real maybe this is really happening and their memories of that pain are more and more distant their memories of all the risks the memories of all the layoffs and the bankruptcies become more and more distant and then they become more and more confident and more and more eager to invest and so they start investing and spending more and more they start hiring the and and because of all of that they see fewer and fewer bankruptcies fewer and fewer layoffs hiring is starting to occur people get more and more and more optimistic and so the economy keeps growing and when you go to points right around here it's been a long time since anyone really talked about major layoffs and bankruptcies and people you know and and foreclosures and all the rest and so people over here are feeling super super confident and they're probably under playing risk at this point and they're investing money they're spending money like there's no tomorrow because they think there'll always be good growth they're essentially extrapolating the recent past and so they think and there's actually even been studies that show that even economists when you ask them at this point what's the the foreseeable future going to look like they tend to extrapolate the recent past so say the recent past we were growing like that so in the future we will grow like that but at this point essentially people are being too bullish they're being too too optimistic and they're probably miss allocating investment and then as soon as things things don't grow as people expect they start getting a little bit fearful but they're still in denial at this point they get a little bit more fearful but here they say oh my god something is going on they start panicking they all start happening economy recedes and then we get but we have the entire cycle again and to kind of understand this emotional aspect of it this is something i redrew i redrew a graph that always gets that always gets kind of a chain mailed around or sent around during the usually at during every bubble when people start becoming Scott tickle of the growth and economy and it traditionally refers to stock market cycles but stock market cycles are closely linked to actual economic cycles and I think these words really do capture the emotional sentiment of what's going on in either during the business cycle or during a stock market cycle is that right when we're you know in the mist in the middle of an expansion people are feeling pretty optimistic a little bit further into it people are feeling excitement they're saying hey maybe this is kind of a new type of thing maybe we're going to be able to grow forever then there's a thrill there people just the last few years all they do is they remember making money they say well I'm going to put all my money in the stock market I'm going to start buying pets.com and whatever else and then there's euphoria there's like wow easy money I don't have to work for a living I can just keep flipping houses or buying stocks of pets.com or whatever else day trading and then all of a sudden you have some signs that maybe there was some bad investment that people's investments weren't turning out as good as they expected people get a little anxious anxious but then as you still proceed this they start denying it they say you know some people say is this are we in a recession thing no no no we're not in recession it's been so long since we're in recession things are different this time the internet changes everything housing never goes down but then as it continues as a recession really does continue they start to get fearful they start say wait maybe this is something going on then desperate then panic and that's when people really if you think of a stock market cycle really start to sell in the case of a regular business cycle they start to maybe under spend they start to really hoard things then capitulation this is when they say ok things are just bad they're never going to get any better and then they become despondent and eventually you could really say emotionally people start getting depressed because they say well it's been so long since we felt all of these good emotions right over here and as many good investors will tell you this is the best time to invest this is the worst time to invest but then there's been so long even though there's maybe a little bit of growth right over here it's been so long since we experienced all of these emotions people are depressed but then as the growth continues they start to feel hopeful a little relieved they say hey at least we're not getting worse and worse and then you get back to optimism again so keep this in mind because in my mind the emotions really are the main factor that are playing in either stock market cycles or economic cycles but when we study it kind of basically in an economics class we're going to take a take human emotions a bit out of the picture which is a little bit artificial because they might be the most important part of the picture
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