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Lesson 4 : Aggregate Demand and Supply

Module 1: Macro Fundamental Analysis

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Video Transcript

So in this module we’re going to look at global macro objectives and we’re also going to be taking a look at some very important key models that you will have to understand in order to get a handle on what’s happening in the economy and therefore also in the markets themselves

so the primary objective of creating a macroeconomic outlook is to determine current and future states of the following four major economic factors so these are the four key economic factors you need to consider at all times in order to be able to assess the performance of an economy growth so you’re talking about gdp

unemployment

inflation and trade so the trade balance of that economy so these four factors these metrics of economic performance are considered to be coincident economic indicators meaning they reflect what is happening right now in the present or even slightly in the past in any given economy at any moment in time so these are not forward-looking pieces of data these are the main metrics of an economy which other data seeks to predict in advance

markets are considered to be discounting mechanisms meaning they are forward-looking in terms of the underlying economy and the business cycle macro trading and investing operates on the principle that markets move in line with the underlying economy the majority of the time now we have in italics here the word majority because this is not a science this is not exactly 100 of the time the markets will always move in line with the underlying economy there is generally speaking a strong correlation between the markets and the economy but for example in a bubble this may be a time when actually the market is rising completely contrary to what is going on in the underlying economy there is some dislocation some disconnect between the markets and the underlying economy so it’s important to know that macro analysis is useful because most of the time the markets will move in line with the economy however just bear in mind this is not the case 100 of the time

so as a result because the market and the underlying economy generally move in the same direction there’s a correlation there most of the time this means that the ability to predict growth unemployment inflation and trade balance provides traders and investors with the ability to predict the business cycle and therefore if you can predict the business cycle i.e you can predict gdp we discussed before they are more or less one of the same then you can also predict broader market moves the majority of the time so again not all the time but the majority of the time that’s the key so in order to predict coincident economic indicators so growth unemployment inflation trade in order to predict those key metrics of economic performance we must look at leading economic indicators

in this course we will assess how to use leading economic indicators to predict changes to an economy’s growth unemployment inflation and trade balance so those key metrics of economic performance

by doing so we can seek to predict market moves and form a fundamental directional bias for currencies on the Forex market as well as for stocks bonds and also commodities

so in short you will learn how to assess global markets and allocate capital accordingly by determining the answers to these following questions what are the leading economic indicators showing first and foremost

what does this mean for future growth unemployment inflation and trade where are we heading in the business cycle

what currencies bonds commodities and stocks are most likely to over or underperform

and then finally how will governments on the fiscal side and central banks on the monetary side respond to these economic developments we can assess effects on growth unemployment inflation and trade by assessing factors which shift the aggregate demand curve and the aggregate supply curve in an economy and we’re going to be looking when we go through the spreadsheet in a minute at exactly what that means and also why it’s very very important to understand so now we’re going to look at forex bond and commodity objectives in order to determine forex bond and commodity market directions we must analyze supply and demand factors supply and demand are key drivers when looking to predict moves in currencies bonds and commodities this is especially true for the foreign exchange market as you can only buy and sell one currency by selling and buying another so it’s relative when we look at stock market objectives i want you to think about it just slightly differently

so in order to determine stock markets direction the approach is the same as it is for forex bonds and commodities so we go through the same process and of course in the stock market there are still supply and demand factors that have to be taken into account however when we are assessing potential stock market returns the primary objective is to determine future growth so think about gdp what gdp is going to be why because gdp is a representation of the entire output of an economy and where is that output coming from in that economy it is coming from the business section out of those three pillars we looked at government consumer business it is the output of the business sector that gdp is reflective of so if you are looking at stocks in terms of either indices or individual stocks you have to have an idea of what the overall output of economy is going to be in order to have an understanding of what stocks representing the businesses in that economy are going to do and how they are going to perform

since gdp is a coincidence indicator the markets tend to move before the gdp data is released each quarter and this is because professional money managers or hedge funds and investment banks this is what we’re talking about here when we say professional money managers they attempt to predict gdp and they take positions in the markets before the data is released so to put that in the most simplest terms as an example it would be the following hedge fund xyz believes that gdp is going to be released at the end of this quarter and it is going to be higher than expected and it is going to be increasing therefore they will buy stocks now at the beginning of month one and as if they are correct the next three months play out stocks will rise and then gdp will be released at the end of the quarter showing an increase and that will be reflective of the stocks rising in the previous three months does that make sense so they are not looking to actually trade the gdp data in fact when gdp data comes out at the end of the quarter if they are correct and they have made money they will tend to liquidate those positions so if you are looking at gdp data and you are going and buying gdp data because it comes out positive you probably find it’s going to end up turning on you because hedge funds and investment banks have already made their money and they actually are just liquidating their positions now they’ve been proven correct at the end of the quarter and they’ll be forward looking to the next quarter so some very important points there if you’re taking notes i would suggest you write those down the two main points there being one that the markets are forward-looking and that’s because markets are discounting mechanisms when the gdp data is released that will reflect generally speaking most of the time so roughly let’s say seven times out of ten depending on what market or index you’re looking at but most of the time that increase or decrease will actually reflect the stock market moves in those three months so it is no good waiting for gdp to come out and then trading it you need to have an idea of what gtp is going to be so that you can position yourself in at the beginning of the quarter and then when the gdp data is released it will reflect the moves in the market so if you think gdp is going to increase and you buy stocks and it does increase then stocks will move positively over that quarter and the second key point is just to think of stocks in terms of gdp primarily and forex bonds and commodities in terms of supply and demand and the reasoning behind that will become much clearer as we go through the course

so simply put since the market is a discounting mechanism stock indices will tend to move in line with real-time changes in gdp so this means that the majority of the time and you can take seven times out of ten as a rule of thumb across the board a stock index will rise or fall and then gdp data will be released which coincides with the rise or fall in the stock index so obviously if the stock market rises gdp is generally released positive the stock market crashes it’s released negative what this means is it means that if you can use leading economic indicators to predict gdp so the output of an economy it will actually mean that seven times out of ten you’ll be able to identify stock market direction by the end of the quarter this is also by the way the reason why the stock market itself is considered a leading indicator and markets in general are considered leading indicators price as we will see much later in the course in the technical analysis section is in and of itself the leading indicator when looking at a chart please download the attached spreadsheet for global macro objectives with key economic models and we’re going to dive over to that spreadsheets now and have a look inside okay so we’re going to start off on the first tab here labeled aggregate demand so first of all what is aggregate demand so aggregate demand is the total demand for goods and services in an economy at any given time now when you look at this spreadsheet here don’t worry too much about these tables okay these are just simply the inputs for this chart over here as well as these tables over here these numbers are just simply the inputs for this chart to create this chart over here so don’t worry too much about exactly what these numbers are the exact numbers themselves are not especially important so if we look at the first chart here on the left you can see down the y-axis we have price level so this is the general level of prices of goods and services within an economy so it’s the general it’s an average level of prices they will take a basket of goods and services in order to calculate that level of prices and changes to the general level of prices up and down are represented by inflation or deflation so inflation and increase in the general level of prices of goods and services within an economy so going up the y-axis inflationary and if the general level of prices of goods and services in an economy declines or it starts to come down it drops the average level drops this is deflationary so coming down the y-axis is deflationary the general level of prices of goods and services within an economy is declining as we go from say six to 5 to 4 and of course 1 3 to 11 these are just arbitrary numbers these are not reflective of any given economy they’re just for demonstration purposes but as we come down the y-axis this is deflationary and as we go up the y-axis this is inflationary so if we come and have a look now on the x-axis down here you can see naught through to 1400 we have plotted real gdp so real gdp just simply gdp adjusted for inflation and we will discuss more in the future gdp module the differences between real gdp nominal gdp but for the time being you just need to know that on the y-axis we have plotted inflation or the general level of prices and inflation technically inflation is actually the changes or deflation the changing of the general level of prices it’s not the actual level of price itself so six for example as a point on the y-axis is not inflation it’s the change between say six to seven and inflation is always an increase which is the inflation okay so it changes to the y-axis not the y-axis itself that is representative of inflation and down here we have real gdp you can see we have the formula here for aggregate demand so why real gdp in economics terms is symbolized by the letter y so y real gdp equals c plus i plus g plus nx and this c plus i plus g plus nx is the aggregate demand formula which we have down here so what exactly then is the aggregate demand formula well the aggregate demand formula is simply the different inputs which make up the total aggregate demand in an economy so really when we’re looking at this line down here this is what’s known as an aggregate demand curve so 81 is simply the aggregate demand curve but having shifted and we’ll discuss this in a moment and this line down here on this chart is the sras this is the short run aggregate supply curve so when we’re looking at this chart it’s actually quite straightforward we have the total amount of demand so we’re just looking at demand and supply curves but because we’re looking at it on a macro level we’re looking at it in terms of total economy it is determined as aggregate so total demand and aggregate supply total supply okay so when we talk about the aggregate demand formula all we are simply saying is what are the components what are the factors which make up total aggregate demand in an economy and we know down here that is c plus i plus g plus nx so what is c plus i plus g plus nx c stands for consumption so this is the consumer how much the consumer is willing to go out and spend is the first factor in aggregate demand how much aggregates demand there is in an economy the second factor here which is i is investment so we’re looking at this now from the business side so we’ve already looked at the consumer remember the three pillars of an economy that we looked at so you had consumer business and government we’ve looked at the consumer already the second component of aggregate demand in an economy so total demand for goods and services comes from investment and this really is the business section of the economy so if businesses for example want to expand their operations they may go out and invest or buy more capital and this creates demand for those goods and services and the third input here of the aggregate demand formula is g and this accounts for government spending so that’s the third pillar in the economy that we looked at in terms of consumer business and government so you can see that the behavior of the consumer of businesses who are investing consumers who are buying and the government who is spending and this could be on a number of things which again we will look at further on in the gdp module but the combination of spending from the consumer from businesses and from government is what makes up total demand within an economy so the key word there being within because that is the demand that comes from inside that economy and then of course you have nx which comes from outside and those four factors make up the total demand for an economy and you can look at this as being a closed economy so this makes up the total demand of all goods and services in a closed economy remember like we looked at before so this is your closed economy

and the fourth and final factor in aggregate demand so how much demand there is for goods and services within an economy comes from net exports so now you’re starting to look at it in terms of an open economy because of course in the real world economies are not closed they trade and they engage in importing and exporting so if you have consumption investment in government spending within a closed economy you also then have to add in the factor in the real world of other countries other economies seeking products from that economy as well and therefore demand comes from the outside as well as the inside and that is when you would be considering that fully as an open economy so when we’re talking about demand or total demand in economy we know we are looking at c plus i plus g plus nx so consumption plus investment plus government spending plus net exports and net exports nx is just simply exports minus imports and it’s important to note that when you’re looking at consumption investment government spending and net exports you are looking at these in monetary amounts so this would be for example consumption would be three billion let’s say it would be a lot more than that generally speaking but let’s say for argument’s sake consumption is three billion dollars investment is three billion dollars government spending is three billion dollars net exports is three billion dollars then overall gdp would be c plus i plus g plus nx so it would be 12 billion dollars so again you’re looking at this in terms of a monetary value that’s very very important to remember so you can see here that if for example we were to increase consumption in any given year gdp would increase if we were to decrease investment if investment was to decrease in the economy in any given year gdp which is symbolized by the letter y would decrease if government spending was going to increase let’s say it were to double

this would have a positive effect on gdp on output if net exports so if let’s say there was an increase in the amount of net exports so a an economy or a country became more of a net exporter you can see gdp would increase so in this scenario let’s say consumption has gone up investment for whatever reason has gone down very slightly government spending has increased and net exports have risen you can see gdp has actually real gdp this is has increased from 12 previously to 16. so what this will show on this chart above is a shift in the aggregate demand curve to the right so aggregate demand has increased and it’s important to note down here that the consumption investment government spending and net exports is the aggregate demand part of this equation and y is gdp but you can see that aggregate demand

equals gdp

okay so gdp and aggregates demand are actually two separate things gdp is in relation to the total output of an economy but the output of an economy will be equal to the demand in that economy