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Lesson 5 : Aggregate Demand and Supply 2

Module 1: Macro Fundamental Analysis

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Video Transcript

Okay so what does that mean then if we have an increase down here of aggregate demand so a combination an increase in the value of a combination of consumption investment government spending and net exports well let’s see what happens on the chart so if we take our ad curve so this is our aggregate demand curve one and we shift it to the right to represent an increase in aggregate demand if there is a decrease you can see over here the aggregate demand curve shifts to the left but we’re talking about an increase here in aggregate demand so total demand in an economy goes up this shifts the aggregate demand curve to the right and the effects of this are as follows so the general level of prices you can see if we draw this across to the original equilibrium point so the point at which the aggregate demand curve meets the aggregate supply curve where they intersect and you can see we start off with a general level of prices in the economy of around five and real gdp is around 600 so this would be 600 billion and this may be five dollars of course it would be a lot more but let’s just say five dollars and six hundred billion we would label this as our p1 and this becomes our y1 so real gdp one price level one and you can see when we shift the aggregate demand curve to the right when there’s an increase in total demand in an economy what happens is the equilibrium point shifts right as well you can see that our new

gdp level down here which we would label as y2

shifts right as well so gdp has now increased because of this increase in demand from 600 billion let’s say to 700 billion and you can see also the general level of prices of goods and services in the economy has shifted from p1 to p2 so what does an increase in the general level of prices of goods and services in an economy mean it means inflation we’re moving up the y-axis so the effect of an increase in aggregate demand so the effect of an increase in total demand in an economy is that growth increases gdp increases unemployment decreases because growth and unemployment are inextricably linked as growth increases businesses will employ more workers therefore unemployment goes down inflation increases as the general level of prices rises and the trade balance of the economy generally goes down now because we are looking at demand factors here you can see the inflation is known as demand pull inflation and this is something we’ll look at in more detail in the inflation module later on in the course but if you’ve ever heard the term demand for inflation this is what is meant by it now the next thing to note is that the gap between

y1 and y2 in this case is a positive output gap so there has been an increase in gdp and this is known as a positive output gap or an inflationary gap so when you hear the term positive output gap this is what is being referred to so you may be asking yourself well why does supply increase so why does total output increase so a shift along the short run aggregate supply curve why does that happen if aggregate demand increases well it’s just simply if you were a business for example and don’t forget short run aggregate supply is the total output of all businesses in the economy if you are a business and suddenly you find there is a lot more demand for your products or your services then you will start to make more products or you will start to hire more people in order to provide more services because the demand is there so they seek to meet demand by increasing their output there is an incentive to increase output because of the higher demand and also because of the higher prices so because prices go up this is the reason the short run aggregate supply curve is sloping upwards as prices increase so you start down in this area as prices increase output also increases because at higher price levels businesses are incentivized to produce more in order to make more profits why is the aggregate demand curve downward sloping and why would there be a shift along the aggregate demand curve well it’s the opposite effect it’s the bargain mentality as price comes down so as the general level of prices of goods and services in an economy comes down aggregate demand actually increases

so gdp actually increases as prices come down why because there is more incentive to consume to spend as the general level of prices comes down because people see that there is a bargain or there is a sale on and the sale mentality takes over so there’s an incentivization for consumption at lower prices and there’s an incentivization for production at higher prices so just remember when you are looking at an aggregate demand curve or an aggregate supply curve you can have a moving along of the curve so you’re moving along the curve and if you’re moving along the curve so demand aggregate demand is increasing or decreasing it is because along the curve this is directly linked to price so it moves along the curve due to price related factors so if price goes up it shifts to the left if price goes down demand increases so higher prices less demand lower prices more demand now aside from moving along the aggregate demand curve you can shift the aggregate demand curve so output doesn’t increase as price is coming down it means that output actually increases at every given price point along the spectrum so you can see this on the left hand side because the first column we have up here is representing the first ad curve and the second demand schedule down here these are called demand schedules these tables this demand schedule is representing the second line and you can see at every given price point in the first demand schedule as price declines output increases because aggregate demand increases as prices come down in the second demand schedule you can see that as prices are coming down gdp is actually increasing at every single price point so at the price level of 10 instead of 100 gdp you would have 300 at nine it’s also increased from two to four at eight it’s increased from three to five at seven it’s increased from four to six etc makes sense so moving along the curve price related demand goes up and down as prices go up and down shifting of the curve gdp output actually increases at every given price and they’re non price related factors which shift the curve so if we get a shift to the right of the aggregate demand curve you can see this would be beneficial this is something that governments and central banks would look to obtain as an objective as a macro objective because it stimulates growth and it also decreases unemployment now with the stimulation of growth also comes inflation as we discussed before the demand pool and there is a slight negative feedback in the trade balance because as you get inflation this means that the general level of goods and services within that economy are rising so exports become less competitive and imports actually may become more competitive because if domestically prices are rising consumers within that economy may decide to instead of spend their money in the domestic economy to buy said product they may go and import the same product from abroad if they can get it cheaper because inflation may be relatively lower in the other economy now in terms of the trade balance something to think about is that if for example you have inflation in one economy the trade balance may not actually be effective if the value of that currency depreciates by the same amount as the inflation rate so for example if you have the price of a product rising by 10 percent in an economy it becomes internationally perhaps 10 less competitive however if the currency of that economy also devalues by 10 relative to another country for example who may be looking to import that product then there is no loss of competitiveness because in real terms it actually costs the same so you may be asking yourself well why would you put trade balance decrease if in some cases it may not decrease and the answer is because when you’re looking at economic models you have to understand you are looking at a simplified version of an economy which is extremely complex and there is a principle when looking at economic models of ceteris paribus meaning all other things being equal so using the principle of ceteris paribus if there is inflation goods and services within that economy will become less competitive internationally ceteris paribus so all other things remaining the same so it’s making the assumption that there is not a devaluation in the exchange rate okay so when you go through economic models you have to understand that they are making assumptions on the basis of all else remaining the same all else being equal ceteris paribus so the term given to this shifting of the aggregate demand curve is inflation and if this shift in aggregate demand is caused by central banks or government in the form of monetary policy for central banks or fiscal policy in the form of governments then the term given to that is reflation and this is what you see after a downturn generally speaking in the economy this attempt to reflate the economy to stimulate growth and to reduce unemployment creating inflation along the way

so finally on the right hand side here we just have the opposite of everything we have discussed so far on the left-hand side so a decrease in aggregate demand so the combined value of consumption investment government spending and net exports decreases we have a contraction in gdp do you remember when on the left-hand side we started with three three three three and it was representing 12 in terms of gdp if we have a contraction so everything declines by two-thirds we go from 12 gdp in terms of value so 12 billion to 4 billion let’s say and this contraction in gdp is a shift to the left of the aggregate demand curve if we plot this on the chart just as we did before you can see that we can start off here from the ad intersection of the sras curves over here the equilibrium so e1 our first equilibrium point you can see we actually if we expand this out to the left we come to a price level of around six and if we bring this down we have a gdp output of around 700 okay now that would be our e1 here is our y1 so gdp output level 1 and here is our p1 if we then have a shift to the left so we have a decrease in aggregate demand you can see gdp contracts shifts left our new equilibrium point is down here so this becomes e2

and at e2 you can see if we shift this out to the left we have a new price level of five so we go from p1 to p2 and if we shift this down and we’re working on quite small charts here if we shift this down we have a new output level here at y2 of around 600. so you can see there has been a contraction in gdp from y1 to y2 so output 1 to output 2. and there has been a decrease in the general level of prices of goods and services within the economy this is what’s known as deflation and if we have deflation here and we have a contraction in the economy the gap in output between y1 and y2 is known as a negative output gap in the economy or a deflationary output gap so as you can see a shift to the left in aggregate demand is not desirable and this is what you will see during a recessionary period this has a negative effect on growth growth contracts unemployment rises as companies look to save on their wage bills and other costs inflation goes down so actually not necessarily even inflation because inflation is the increase in prices we in fact have deflation instead of inflation and the trade balance slightly increases ceteris paribus because prices of goods and services in that economy are now cheaper and therefore more internationally competitive