We've talked about long-run potential GDP

and we've also talked about

the aggregate supply

and aggregate demand model.

Today we're going to put them together

to talk about business cycles.

How can we show the relationship

between actual and potential GDP?

One way is on our aggregate supply,

aggregate demand graph.

Recall that the horizontal axis

is real GDP

which we sometimes refer to as output or Y.

Potential GDP shows up in this graph

as a vertical line

often called Y star

or the long-run aggregate supply curve.

Why is it vertical?

Remember that the vertical axis

is the economy-wide price level.

The LRAS is vertical

because the price level

can change all over the place

but potential GDP stays the same.

That's because it's determined

by labor force, capital stock,

and productivity,

not the price level.

Then we put in aggregate demand

and a short-run aggregate supply.

As we've seen their intersection

gives us the actual GDP

at any given point in time.

Another way we can compare

actual and potential GDP

is on a time graph.

Here the horizontal axis is years

and the vertical axis

is the economy's total output and income.

Potential GDP is determined by

capital stock, labor force, and productivity.

Those factors change slowly over time.

So potential GDP tends to grow gradually.

At any given time

actual GDP

may be above or below potential GDP.

Starting with actual output

equal to potential,

let's look at what happens

if there's a negative shock

to aggregate demand.

For some reason suppose that

households decide to spend

less on consumption

or businesses spend less on investment.

In the aggregate demand

aggregate supply model

aggregate demand shifts inwards.

Actual GDP falls below potential GDP;

the LRAS.

Meanwhile, on our time graph

actual GDP falls below the trend line

of potential GDP.

Although these graphs

are showing the same thing,

we call the situation

where actual output is below potential,

a recessionary gap.

In this situation

some workers are unemployed,

some capital like factories or stores

are vacant.

In real life this describes

what happened to the economy

after the financial crisis of 2008.

Consumer spending and business investment fell

shifting aggregate demand inwards

and producing a large recessionary gap.

As discussed in other videos,

there are different ways for an economy

to get out of a recessionary gap.

The government may implement

expansionary, monetary, or fiscal policy.

This would boost aggregate demand back out,

raising actual output back to potential.

In many models

output will also return

to potential on its own

if you wait long enough.

Unemployed workers and capital

drive down production costs

which show up as an outward shift

in the short-run aggregate supply.

The move along on aggregate demand

returns output to potential.

In either scenario

the time graph shows actual output

climbing back towards the potential trend.

Starting with actual output

equal to potential,

let's now look at what happens

if there is a positive shock

to aggregate demand.

For some reason

suppose that households decide to spend

more on consumption

or businesses spend more on investment.

In the aggregate demand

aggregate supply model,

aggregate demand shifts outwards,

actual GDP rises above potential GDP;

the LRAS.

Meanwhile, on our time graph

actual GDP rises above the trend line

of potential GDP.

Both graphs are showing the same thing.

We call the situation

where actual output is above potential,

an inflationary gap.

In this situation

businesses are employing

all the workers in capital

they can get their hands on

to produce the highest possible output.

In real life

this describes what happened to the economy

during the 1960's;

a combination of consumer

and government spending

boosted aggregate demand raising output

and resulting in inflation

at the end of the decade.

As discussed in other videos

there are different ways for an economy

to get out of an inflationary gap.

The government may implement

contractionary, monetary,

or fiscal policy.

This would pull aggregate demand

back in lowering output back to potential.

In many models

output will also return to potential

on its own

if you wait long enough.

A bidding war among employers

will raise wages and resource costs

which shows up as an inward shift

in the short-run aggregate supply.

The move along on aggregate demand

returns output to potential.

In either scenario

the time graph shows actual output

falling back towards the potential trend.