Changes in the AD-AS model in the short run
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Real GDP driving price
Male: In our earlier justifications for an upward sloping aggregate supply curve in the short run, we kind of viewed price as the independent variable. What I want to explore a little bit in this video is that you could view it the other way around. You could view that real GDP is driving price. Just to review, this is our upward sloping, the thing that we want to happen. Aggregate supply in the short run. In the previous videos we said, hey, when price increases, this would cause real GDP to maybe expand even beyond its potential, beyond its natural rate. Let's say that this is where it is in the long run, right over here. Let me draw it. This is where it is in the long run, right over here. This is an aggregate supply in the long run. This is the current level of prices. This is all review. Right over here, this is our current level of prices. This is where we're sitting on GDP. In the past we said, hey, if we increase prices because of a bunch of factors, that might cause, in aggregate, the economy to produce even above its natural rate, so you would actually have real GDP expanding, so you have an upward sloping aggregate supply curve. We gave reasons why price might drive this to happen. We talked about the misperception theory, that individual actors in the economy, individual firms, might misperceive the increases in prices as a microeconomic phenomenon and so they would, because of the law of supply, they'd think they were making more real profit. It would take them some time to realize that they aren't. It's just nominal profits that they're getting. On top of that, we talked about the whole sticky wage, sticky cost theory, that some part of the economy there will be increased real profits because in the short term, some players' costs aren't going to go up as much as their revenue are, so they would also want to essentially produce more beyond their natural productivity and maybe overheat their factories and their people a little bit. But I want to talk in this video, and this is true of a lot of economic models, you don't have to view price as driving real GDP. You could really just view it the other way around. As real GDP, if you get utilization really, really high, approaching 100%, and depending on how you define utilization, maybe going even above 100%, that that might actually drive prices, or that maybe they are driving each other. One way to think of it, and really this is just another justification for an upward sloping aggregate supply curve, but we're just doing it a different way. Now we're saying this is our natural rate of productivity. If we're asking people to produce more, then they're going to want to charge more. The way to think about this, and at the end it's really not going to help them because everything's going to get more expensive. They're going to produce more but they're not going to, on a per unit basis, not get much more real profit. But in the short run they might, or they might think they are, so they might want to do it. The one way to think about this is if you view this bar, the area of this bar, as the capacity of a firm, the capacity of a market, capacity of an entire economy, then maybe its natural, its potential, maybe it's sitting here at maybe 85% utilization. If the factory could be producing widgets or cars or whatever 100 hours a week, its natural state is it's actually only producing 85 hours a week and that's because it needs to use that other 15 hours to let the factory cool down, or to do repairs and maintenance or inspections of some sort. But let's say that for whatever reason, maybe a war starts, and the government demands that more things get built, more widgets get built, more tanks get built, more materials need to be developed, that they're essentially asking people not to do some of these things that they would have to do if they want to be sustainable in the long run, and they ask the factories to produce more, to start getting to 90%, 95%, maybe even 100% utilization. You can imagine in this situation all of the firms ... a firm is all about maximizing profit ... they will raise prices when they can raise prices even though in the long run it will just be a nominal increase. It won't necessarily be a real increase, but they'll feel in the short run that it is kind of a real increase in prices, and so they will do that. Instead of them trying to build more capacity, they might even view it as a short run thing, so they'll say, hey, no, you're going to have to pay us a lot of money for our employees to work overtime. Maybe that's even in some of the contracts that you have to pay more for them to work overtime, for me to defer some of my maintenance and other things that I was going to going to do, or kind of defer investment for me to just produce all out right over here. I'm just describing the same upward sloping curve but with a different narrative. Instead of saying that price is driving real GDP expansion because of the misperception theory and sticky prices, I'm saying that an increase in real GDP and an increase in utilization will drive prices. They're just two ways to look at the same thing. You can even apply that to some of the ideas that we talked about in the last video. In the last video, you might not have even had to resort to the Aggregate Demand Aggregate Supply model. You might not even need Aggregate Demand Aggregate Supply to understand why we had inflation in 1966 and 1967 and really the late '60s generally. All you would have to do is think about entering into, or the beginning of LBJ's administration, the economy was already at high utilization. Unemployment was only at around 4% or 5%; 95%-96% of the labor force was employed. Factories were operating at high utilization. Now we escalate the war. We're taking people who could have been employed in the domestic economy and they're going and fighting in battle. We need bullets, we need boats, we need fuel, we need all of these things. We need to utilize more of domestic capacity to produce all of these things, so you can imagine that this dynamic was occurring; that you had to get firms and people to tap out all of their extra capacity, and then to do so they're essentially going to demand higher wages and higher prices. We wouldn't have necessarily even had to resort to this to predict this higher inflation. Another way to think about it is this is another way to justify an upward sloping aggregate supply curve in the short run, which is another way that we described the same dynamic. They're all heavily, heavily related.