Changes in Velocity

Welcome back to the aggregate demand - aggregate supply model. In the previous video, we focused on what happens when the aggregate demand curve shifts due to a change in the money growth rate. Now we're going to ask what happens when AD shifts because of a change in "V". This time, we'll assume the money supply is constant. You can think of velocity as how often money changes hands. So, an increase in V means that spending has increased because money is changing hands at a faster rate. It's useful to recall the National Income Spending Identity -- Y = C + I + G + NX.

Now all this does -- it just breaks spending down into different categories. So, if V changes, then the growth rate of either C, or I, or G, or NX must change. For example, suppose that the government starts spending a lot more -- say a big increase in defense spending. The increase in spending shifts out the aggregate demand curve. So, in the short run, the economy moves from point A to point B, creating a higher growth rate, a boom from all that defense spending, and also a higher inflation rate, as that spending pushes up prices.

That's the short run. Now, what happens in the long run? Well, in the long run, government spending growth has to return to normal. Government can't keep growing spending at a higher rate forever, because, in the long run, government spending can't grow faster than the economy grows. So, in the long run, the aggregate demand curve shifts back, as the growth rate of government spending returns to normal. So, after the boost in spending works its way through the economy, we return to point A. So, changes in M and V shift the aggregate demand curve in slightly different ways.

The money supply growth rate can be increased or decreased permanently, but changes in V are always temporary. The best way to remember this is that, in the long run, we have to be on the long-run aggregate supply curve. And, in addition, in the long run, the inflation rate is determined by the money supply growth rate. So, if the money supply growth rate hasn't changed, then the inflation rate can't change in the long run either. Now even though changes in V are always temporary -- an increase in V shifts the AD curve out, and then back. A decrease in V shifts the AD curve in, and then back. Even though these changes are temporary, they can still cause business fluctuations. And if the changes are big and very negative, these changes can even create a recession.

Let's illustrate with another example. Suppose that "C," consumption growth, decreases. Now why might this happen? Fear. Imagine that consumers suddenly become pessimistic and fearful about the economy, as they did in 2008, when it looked like the banking system was on the edge of collapse. Workers and consumers, fearing that they might lose their jobs -- they cut back on their spending. They try to hold onto their money. Instead of buying a new car, they hold onto their old car. They decide that now is not a good time to remodel the kitchen. They start saving more money -- just in case. The "animal spirits" -- to use John Maynard Keynes' famous phrase -- they've "turned negative." The decrease in consumption growth shifts the AD curve inwards.

In the short run, the decrease in spending moves the economy from point A to point B, where inflation and real growth are both reduced. In the long run, however, fear recedes, prices and wages adjust, and the economy moves back to point A. Now, by the way, if you're thinking, "Why don't we try to offset the fall in C with an increase in G?" Good thinking! That's the idea behind fiscal policy, which we'll take up in greater depth in a later video in this course.

For now, let's sum up. Let's review some of the causes of the shifts in the AD curve. Since M is money supply growth, and V can be broken down into C, I, G, or NX, the causes boil down to anything that can affect these factors. So, for example, faster money growth shifts the AD curve outwards. Slower money growth, especially slower than expected -- that shifts the AD curve in. For consumption, confidence and fear -- that could increase or decrease consumption growth. Confidence and fear -- animal spirits -- these are also big drivers of investment. Big changes in tax rates could have similar effects, with lower taxes increasing spending, and higher taxes reducing spending.

As we've already discussed, increases in government spending shift the AD curve out, and decreases in government spending shift the AD curve in. Finally, since NX is equal to exports minus imports, an export boom would increase domestic aggregate demand, as would a cut in imports. For the same reasons, a decrease in exports, or a boom in imports, would reduce domestic spending, and shift the AD curve in.

Now don't try and memorize this list. As always, it's better to understand the logic. Forces that increase spending -- that shifts the AD curve out. It causes a positive shock to the economy. Forces that decrease spending -- that shifts the AD curve in, and causes a temporary negative shock to the economy. Okay. That's our aggregate demand-aggregate supply model. We can now use the model to understand the most devastating economic fluctuation in U.S. history: the Great Depression.