 In this segment, we're going to talk about what I think of as the curious nature of the aggregate demand and aggregate supply analysis that's presented in the textbook. This is a little difficult to do without having a graph or a blackboard or something to show you, but I'm sure you're familiar with this from the text. The graph we're talking about is a graph which has income or output on the horizontal axis and price index on the vertical axis. Aggregate demand is a curve that shows that when the price level falls, aggregate demand rises. And when the price level falls, aggregate supply shrinks. And then there's an equilibrium point in the middle and the answer to the question of what determines output and the price level is the intersection of the aggregate supply and aggregate demand curve. Now let's take a very important example of how this works. Suppose the price level is too high so that we're above the intersection. This will mean that aggregate supply is higher than it would be at the equilibrium point, but aggregate demand is lower than it would be at the equilibrium point. So since aggregate demand or what people will spend determines output and production or supply, we will have an output level that's too low, an employment level that's too low, and an unemployment rate that's too high. It doesn't mean that we have a lot of unemployment. So what's going to happen with this? The fact that businesses are trying to produce more than people will buy means that the price will come down because they can't sell the goods. And when the price comes down, the aggregate demand curve says employment will rise. So basically what's argued here is that a process of deflation, which is a process of falling prices, is the mechanism that causes employment to rise and unemployment to go down and to shrink and get us back to the equilibrium position. Now the reason I said this is curious is because no one believes this. No one believes that deflation is a mechanism that will raise aggregate demand or expenditures and employment. No one believes that it could do this. No one believes that it does do this. So this is really extraordinarily curious. I'll explain why nobody believes this in a moment, but you might ask yourself, well, if no one believes it, why do you have to study the damn thing in your class? And the answer is it's kind of neat for economists. Economists have laws of supply and demand, which essentially explain everything. So if you study the labor market or the goods market or the market for peanuts or the market for cars, economists like to say we can organize all the determinants of the things that will tell you how much will be produced in the price in a supply and demand grid. So the tendency to want to explain what determines total output in the economy and the total price level in the economy through a typical supply and demand analysis is kind of compelling, and so I think economists like to do it. Why do I say no one believes it? The first reason is we could look at the data that lots of people have studied the effect of inflation or deflation on economic output and employment. So what's the consensus finding? The consensus finding is that within at least certain limits, higher inflation raises output and lowers unemployment, and lower inflation does just the opposite. If you have less inflation, if prices aren't rising as much, you actually get less output and more unemployment. And all policymakers and economists desperately fear deflation. Nobody wants deflation. The Fed has said in various occasions in the past decade that if they think there might be actually falling prices, they'll want to stimulate the economy. So all the data suggests that this is just not right. The aggregate demand curve isn't correct. You might say, and the tech sometimes say that we can explain this because let's suppose that you're making whatever wage you get, and all of a sudden prices go down. You say, well, OK, I now can afford to buy more goods because I have the same income and prices have gone down. But this is cheating. You can't do this because in a general deflation, what happens is all prices come down. The price of the goods comes down. The price of your wage comes down. So essentially, you don't have any more money to buy goods than you would have had if the prices didn't fall. Another problem is, and this is a big problem, if we have serious deflation, this means that your income comes down, your wages go down, business profits go down, all the incomes of all the sectors of the economy come down as all the prices come down. But there's one thing that doesn't come down. And that's the size of the debts that you owe. So if you have a mortgage, if you have credit card debt, if businesses have borrowed money to build plant and equipment, they still have to pay as much as they did before. So deflation means that everyone is less able to pay their debts, which means that there'll be defaults on their debts. If the defaults on their debts are mild, they're not too many of them. This will be bad for the banking system. And it will be worried about its own solvency. So it won't loan to people. So it'll cut down the loans it will give to households and businesses. This will lower expenditures, shift the aggregate demand left, and lead to more unemployment. If defaults are serious, like they were in the housing market recently, this can lead to the bankruptcy of financial institutions. And if financial institutions are bankrupt, and there's a huge problem, is the whole financial system freezes up. So the mechanism, which is supposed to kind of cure the problem by increasing expenditures, which then decreases unemployment, actually works in a reverse fashion. And if your debt burdens go up, and if there are defaults, and if the financial system is put under pressure, there's aggregate demand curve will shift left, and the situation will be much worse. So what do you have to do if there's unemployment really? And the answer is, you have to figure out some way to shift the aggregate demand curve to the right. How do you do that? Well, maybe business gets more optimistic and can do it. But generally, if it's a problem that's significant, the government has to come in as the only sector in a difficult situation, which can spend money, cut taxes, run monetary policy, and in that way, stimulate output and employment, save the banking system, avoid the problems, and so forth. But you still have to learn how to explain aggregate demand supply in your test.