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Lesson 6 : Aggregate Demand and Supply 3

Module 1: Macro Fundamental Analysis

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Video Transcript

In this video we’re going to look at the short run aggregate supply curve and how shifts in the short run aggregate supply curve affect the overall economy and in future videos we will be looking at how these effects on the economy create market moves in currencies stocks commodities and also bonds so we will be linking what we’re discussing here to the markets in future videos so we have already discussed in previous videos why the short run aggregate supply curve is upward sloping and how as price increases supply also increases due to the incentive to produce more at higher prices so if businesses can sell products for a higher price they are incentivized to produce more of those products as it becomes more and more worthwhile as prices go up so you will also notice down the bottom here that we only have one tab for aggregate demand but for aggregate supply we’re talking about short run aggregate supply and we will be very soon talking about long-run aggregate supply and this is because in the classic model the short-run aggregate supply curve and the long-run aggregate supply curve are two separate curves so just a note to any Keynesians out there who would argue that no there is not two supply curves there is actually only one and it would look something like this

please note that this is a trading course and yes you can argue about the nuances between the models and also about sticky wages but we’re using the classical model here just to convey the ideas behind these models and how shifts in the supply and demand curves at the aggregate level affect the economy and therefore affect the market so just bear that in mind and if you prefer to use Keynesian models then fine so if we look at the tables on the left here which are known as supply schedules as they are in relation to the aggregate supply curve you can see this confirms what we’ve just been discussing which is that as the level of prices increase so too does output so two does real gdp as price level decreases so too does real gdp so two does the total output so as prices go up there is more of an incentive for suppliers to produce and they will produce more as price levels decline there is less incentive for producers to produce goods and services and therefore they will produce less gdp will contract total output will decline so before we assess the effects the economic effects of an increase in short run aggregate supply let’s just have a look at why the short run aggregate supply curve may shift to the right or to the left so we’re talking about short run aggregate supply we’re talking about the output of businesses and industries so shifts in the short run aggregate supply curve stem from changes to the costs of production in other words if the costs of production for businesses decrease and their profits therefore increase generally speaking businesses are motivated to produce more if businesses costs of production increase and suddenly businesses are making less profit then they are disincentivized to produce more and in fact they may even produce less this is what will shift the short run aggregate supply curve to the left there will be a decrease in supply of goods and services within the economy so when we talk about costs of production you can think of this more specifically if we talk about wages if the general level of wages came down for whatever reason then businesses would be making savings on one of the biggest costs of their entire business which as we discussed before is the wage bill and therefore they would be generating higher profits in the short term because they would likely still be selling they would not pass those savings on to the consumer so as their costs go down as their wage bill goes down assuming they don’t have to fire anyone and they can keep the same level of output their profits will increase when we look at input costs you may have commodities in terms of input costs which are turned into something else so you may have gold if you are a jeweler and you are creating gold rings out of gold bars just as an example then if the price of gold goes down and you in the short term are still selling your gold rings at the same price you will be making an increase in your profits you may have a commodity as an input cost which is not used to produce something else but is used to actually run the business so think of airlines think of haulage firms who are very sensitive to changes in the price of oil if the cost of oil declines companies which use a lot of oil in their operations will see their costs go down and their profits margins will increase and as profit margins increase they are actually encouraged and motivated to produce more you may even we haven’t listed it here but you may even see a decrease in taxes in corporation tax a cutting corporation tax would show more profits it’d be a reduction in costs in terms of taxation for businesses and it would increase profit margins this would also increase aggregate supply in the short term you would see a shift to the right in aggregate supply so anything which affects the costs of production in a business will also affect the short run aggregate supply and if costs decline this will increase aggregate supply and if costs go up this will decrease aggregate supply or what about subsidies you could have a subsidy which is given to a business from the government and this would have very similar effect to a reduction in corporation tax so the provision of a subsidy to a business would see short-term aggregate supply of that business shift to the right it would see an increase in output at least in the short term so if we were to draw onto our short run aggregate supply model here you can see that if we take the first short run aggregate supply curve so sras1 and we find the equilibrium point here where it intersects the aggregate demand curve we can see that if we track this left we get an initial price point so p1 of around 60.

we can see if we track this down we get an output level roughly of about 600 maybe just below

and if we find the second equilibrium point here once the short run aggregate supply curve shifts to the right

which is right here so e2 you can see that if we track this down

we get an increase in output so our new output at y2 is around 650 700 let’s say let’s say 700 for argument’s sake and if we track this left we can find that we have a new price level which is lower at around 50 let’s say once again for argument’s sake again the numbers don’t really matter too much these are just for demonstration purposes now we can see here that we actually have when there is an increase in short-run aggregate supply we actually have a positive output gap gdp expands we have growth in the economy and price levels if in reality they do not stay roughly the same they may slightly decline this is deflationary so this is a period of low inflation or slight deflation with positive output gaps in terms of growth and this means that we have an increase in growth a decrease in unemployment as growth and unemployment always move in opposite directions we have a decrease or very low levels of inflation and ceteris paribus the trade balance is positively affected because as the general level of prices for goods and services within the economy declines exports become more competitive internationally so once again if the price of exports declined by let’s say 10 percent but the value of that currency appreciated by 10 percent then there may actually be no change in the trade balance but ceteris paribus lower levels of inflation a decrease of prices of goods and services within the economy is positive for the trade balance and this scenario here where we have a shift to the right of short-run aggregate supply this is what’s known as a goldilocks economy so this is where we have growth with low levels of inflation and this really is a dream scenario for industry and for businesses because as the general level of prices are coming down they have lower costs so they have lower wage bills they have lower input costs but at the same time they are still experiencing economic growth and their output is actually increasing as their costs decrease now factors which shift the sras curve to the left are just the opposite of what we’ve just discussed so the cost of productions increase we could be looking at an increase in wages let’s say you have strong unions in a country in an economy and they drive up the price of wages in that economy businesses will now have a higher wage bill this is a greater cost of production and as a result this would contribute to a shift to the left in the short run aggregate supply so we see a decrease in output from those businesses because perhaps in order to maintain the same wage bill as before companies may need to decrease the number of workers they have causing output to fall you may have higher input costs now this could be in the form as we said before as commodities which are used to make other goods and services so like the example of gold and gold rings if the price of gold increases you may not be able to actually raise the price of your gold rings and as a result you have higher input costs now you may also have high input costs in the form of a commodity like oil oil is a huge input cost for many many businesses all around the world and the price of oil is very very significant to the global economy if you are running a business that utilizes oil let’s say as we said before an airline and the cost of oil increases greatly to the price of oil increases your costs of production have gone up to produce that service all that good as a result this would actually lead to a shift to the left in the short run aggregate supply curve and output would likely decrease we can also look at short-term environmental factors we touched on this before in the video and really the example we give here as in damage to crops could be as easily damaged to machinery perhaps there needs some time for machinery to be repaired after it’s been damaged for whatever reason now although these aren’t quite the costs of production these are actually damage to factors of production but in the short term so when we look at long run aggregate supply in the next video you will see that this is primarily determined by the factors of production and damage to crops short-term damage to machinery short-term they are more factors of production rather than actually costs of production now we can also look at taxes we discussed this before and you can see we’ve added this now into the spreadsheet so we could have an increasing corporation tax for example this would increase the cost of production for businesses an increase in the cost of production would see a shift to the left in aggregate supply supply would drop and we may also look at subsidies now really the opposite of a subsidy is a tax in a sense because you cannot remove a subsidy unless you’ve already granted it but let’s say for example there is a situation where the government has been subsidizing a business or an industry and it then decides to reduce or remove that subsidy that would then see a shift to the left in the srs curve so now let’s have a look at what any of these changes to the cost of production so an increase in the cost of production shifting the sras curve to the left or some very short-term damage to let’s say land or machinery causing this decrease in short-term aggregate supply what effects this would actually have on the economy well if we start off without equilibrium 0.1 which is right here so we just simply label this as e1 you can see that if we shift out to the left from here we get a price level of about 50. so we’ll label this as p1 and if we shift down from here

we get an output of about 700 which we will label as y1 so real gdp reflected by the letter y if we look at the second equilibrium point so the equilibrium point after the shift to the left has taken place in the short run aggregate supply curve we’ll label this e2

you can see that if we shift this left

we actually end up coming in roughly at about 60 maybe just over and we will label this p2

and if we follow this down you can see we have a new output level of roughly 600 which we will label as y2

so what this actually shows us is that any shift to the left in short run aggregate supply this is going to cause a decrease in economic growth so we’re going to have a negative output and this is assuming we’ll come i don’t want to complicate this too much for the time being because we’ll look at this in the next video but this is making the assumption that we start off at equilibrium in the long run but this would cause a negative output gap growth would decrease and unemployment of course would increase because labor is a derived demand so you have that inverse relationship between economic growth and employment inflation actually increases you see we go from about 50 in terms of the general level of prices of goods and services within this economy to about 60 and the trade balance will decrease so ceteris paribus all other things remaining equal if the general level of prices of goods and services within an economy increases this is bad for the trade balance as exports become less competitive now this type of inflation where you have inflation due to rising costs of production is known as cost push inflation this is not desirable as you can see because this comes with negative consequences for economic growth and employment and cost push inflation is really something that central banks and governments would want to avoid the better type of inflation out of the two is demand pool which we looked at in previous videos that is the kind of inflation when you hear central banks enacting monetary policy in order to stimulate inflation they are trying to stimulate demand pull inflation and you can start to see why central banks and governments will work on this on the demand side instead of the supply side because it is much more preferable to have an increase in demand and excess even in demand than an excess in supply so when we have this shift to the left and we have low economic growth with increased inflation this is known as stagflation as i said before this is not a desirable economic condition for any given economy so just remember an increase in the costs of production for a business especially which is very very common is an increase in input costs will result in a shift to the left in short run aggregate supply and this will lead generally speaking to a period of economic stagflation this is not a desirable economic condition this is something that central banks monetary authorities will try to avoid and the type of inflation that comes with that cost to push inflation is actually damaging to an economy as opposed to demand pull inflation and when you’re also thinking about the cost of production when you go through in your own mind a macro analysis you can start to think a little bit outside the box as well what else would affect the input cost of cost of production you have input costs of course if you are importing a product let’s say to use to make another product and the price of that increases then this will be an increased cost of production but what about if the price doesn’t increase but your domestic currency actually devalues against the currency of the economy where you are purchasing that product from there is a relative cost there so this could be viewed as another cost of production eating into profit margins so you see once you start to understand the basic principles here you can actually start to think about this for yourself and try and really work out and dig deep into different scenarios and situations to determine whether you think there will be factors affecting the short-run aggregate supply curve