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Lesson 8 : Inflation, Deflation, Stagflation & Goldilocks

Module 1: Macro Fundamental Analysis

 

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Video Transcript

So in this video we’re going to have a look at putting everything together that we’ve already discussed so here we have the classical AS/AD model we have the long run aggregate supply curve which is labeled as YFE we have the aggregate demand curve downward sloping here and we have the short run aggregate supply curve the upward sloping curve here so let’s think of an example first of all where the ad curve shifts to the right and we’ve labeled this reflation but just remember that definition of reflation is actually central bank monetary policy shifting the aggregate demand curve but let’s say for whatever reason the aggregate demand curve shifts to the right and the shifting to the right of the aggregate demand curve which we will label as ad1 creates a new equilibrium level which is to the right of long run aggregate supply so actual output in the short term is greater than potential output so how can actual output be greater than potential output well we discussed this this is because this is sustainable levels of output that we’re looking at here in the LRAS so as the ad curve shifts to the right you can see that we actually have an increase in growth so real gdp expands and this increase in real gdp is the positive output gap this is the inflationary output gap so the definition of a positive output gap is when actual output is greater than potential output so to the right of long-term lras so we can see when this happens we have greater levels of inflation and this actually leads to demand pull inflation unemployment decreases as economic growth has increased so companies will hire more workers in order to meet increased supply because we shift along the supply curve why because prices have increased they have been bid up by this excess of demand and so supply rises as prices rise because there is an incentive for companies to produce more at these higher prices and to meet this high level of demand and also the trade balance will decrease cetera’s power bus because higher levels of prices of goods and services within the economy makes the exports within that economy less competitive so with this positive output gap we reach a scenario where actual output is greater than long run sustainable levels of output or potential output and by definition this makes this unsustainable in the long term the economy will self-adjust back to long-run aggregate supply now why does this happen well because we’re in a scenario where there is increased economic growth we start to see decreased levels of unemployment so there are more people in work this makes labor more of a scarce resource in the economy because it becomes harder to actually find unemployed people to fill positions now in the short term in the short run this positive output gap can be sustained short term because the price of resources are fixed so wages and rent and contracts these are what’s known as sticky they do not move instantly when there is an increase in aggregate demand instead what happens in the short run the price of resources remain fixed and therefore this is what leads to an increase in economic growth in the long term however wages rent contracts the price of resources are variable so they can be changed and what happens during a period of economic expansion when there is a positive output gap because labor has become more of a scarce resource workers will start to revise up their wage expectations they will demand more money landlords will see more competition in this economic expansion for office spaces maybe for commercial properties so they will increase their rent now we’ve discussed this in previous videos an increase in input cost shifts the short run aggregate supply curve to the left and this is what brings the economy overall back to long run aggregate supply equilibrium levels and you can see in this case when short-run aggregate supply self-adjusts back to long-term equilibrium levels we actually end up with higher levels of inflation in the economy so an increase in the general level of prices of goods and services in that economy in the long run so now let’s consider what may happen in a deflationary scenario so aggregate demand instead of shifting to the right shifts to the left now we may have a situation and it could be for a number of reasons but let’s say there is a pandemic to take a recent example and as a result people stay at home demand for services and goods actually decreases and at all price levels demand has diminished shifting aggregate demand to the left so we can see here shifting to the left of the aggregate demand curve gives us a new equilibrium level offset from long-term equilibrium so actual output is now less than long-term sustainable output so actual output is less than potential output in this economy and this causes a negative output gap so the definition of a negative output gap or a deflationary output gap is when actual output in an economy is below potential output in an economy like we have here so alongside that shifting the equilibrium from e1 to e2 also gives us lower inflation or in fact deflation a decline in the general level of prices of goods and services we get deflation and this coincides with our negative output gap so the implications of this are a decrease in growth as we discuss the negative output gap we have an increase in unemployment levels so again that inverse relationship with growth inflation decreases so we actually have deflation where prices decline in the economy and ceteris power of us the trade balance will actually increase as now goods and services within that economy are more competitive on an international basis exports become more competitive in that economy so what begins to happen is over in this area where we have this negative output gap prices have now declined within the economy so input prices costs of production start to decline for businesses unemployment has increased so this means there is an abundance of workers there is more competition for jobs and therefore in the long run wages can be revised down because workers will actually accept that there is more competition for the job that they have and that maybe the economy is not as in a good state and also their own costs of living have decreased so they are able to actually take a bit of a pay cut in the long run or revise down their wage expectations there is also due to the decrease in economic output so contraction in gdp there are less businesses in operation maybe some businesses have gone bankrupt and out of business altogether and therefore there is less demand for rental properties for commercial properties so landlords will also revise down rent in some cases and this along with the wages and also potentially other input costs in the economy as prices fall all lead to a reduced cost of production for businesses and we know that reducing the costs of production for businesses shifts the short-run aggregate supply curve to the right this shifting to the right of the short run aggregate supply curve brings us back in the long term to the potential output of the economy why because in the long term wages rent and contracts are variable meaning these costs of production the price of these resources can be revised down in the long term during a negative output gap so as we’ve seen here if there is a negative output gap in the economy if there is a recession the economy should over time self-correct it should self-heal back to its long-run aggregate supply level so it’s full employment output level now what happened during the great depression was this wasn’t the case and the depression just went on and on and on and there was no self-healing this actually caused economists including keynes to suggest that monetary intervention was necessary to stimulate demand and shift the aggregate demand curve back to the right and this is why central banks will step in with monetary policy and governments will step in with fiscal policy it is in an attempt to shift aggregate demand to the right primarily to close negative output gaps and really the last thing to notice here is that when the economy does eventually self-heal when it comes back to full employment output so the long run aggregate supply equilibrium level we are left with deflation so we do have a decrease in the economy of the average level of prices of goods and services within that economy even after the economy self-heals back in the long term to full employment output so let’s now think about what would happen in an economy if we had a shift to the right of the short-run aggregate supply curve so creating this goldilocks economy what would shift the short-run aggregate supply to the right or to the left well anything that shifts short-run aggregate supply to the left or to the right so any event which causes a shift in short-run aggregate supply is known as a supply shock any shift to the right of short run aggregate supply as we are looking at in this case is known as a positive supply shock so an example of a positive supply shock in an economy may be the decrease in price of oil so a sharp decline in the prices of oil would see costs of production within any given economy because most businesses within an economy actually utilize oil as an input cost a reduction of the price in oil is a well-known historical supply shock positive supply shock which actually shifts short-run aggregate supply to the right so as costs of production decrease within an economy for businesses we have a new equilibrium in this area and you can see actual output is operating at greater than potential output so once again actual output operating above potential creates a positive output gap this in turn creates a decrease in levels of unemployment inflation in this scenario actually decreases we have deflation you can see e2 our second equilibrium point is actually lower than the original equilibrium point so we have deflation or very very low levels of inflation and of course this helps the trade balance these low levels of inflation or slight deflation actually help the trade balance because exports become more competitive so you can see why this is known as the goldilocks economy because growth increases which is good unemployment decreases which is good inflation is either stable or slightly decreases which is good and also the trade balance increases usually there is a trade-off with the trade balance if you have growth in this scenario trade balance actually increases because of the low levels of inflation so this is really a dream scenario for businesses and for the economy in general and because the price of resources in the short term are fixed this means that wages rent and contracts stay the same for companies and they can actually generate greater profit margins by the savings they’re making on their input costs now as always we know this new equilibrium point outside of long run equilibrium so outside of potential output of the economy full employment output is unsustainable and it will eventually like other conditions self-correct back to long-run equilibrium so in terms of self correction with the short run aggregate supply curve it is slightly different to the aggregate demand curve in the sense that the ad curve does not shift to auto correct the sras curve the sra s curve will shift back into place why because for a short period of time there is a positive output gap in the economy growth has increased unemployment has decreased inflation has gone down or is stable or is low or there is a bit of deflation and the trade balance has increased because of the lower levels of inflation in the economy now when there is growth and when there is a decrease in the level of unemployment in the economy once again labor becomes a scarce resource and with the combination of an increased output from businesses and labor becoming more of a scarce resource in the long run after a while wages and rent and even contracts may be revised upwards so wage rent and contract expectations may be revised upwards to reflect the economic growth and also the lack of competition for jobs when workers become scarce wages will go up and this will increase the costs of production over the longer term and what this actually means is the sras curve will shift back into place as an increase in wage rent contract expectations as an example will actually offset the initial event such as a decline in the price of oil so we’re going to wrap up by having a look to see what the economic consequences would be of a shift to the left in the short run aggregate supply curve so what factors could shift short run aggregate supply to the left you may have for example instead of a decrease in the price of oil you may see a spike in the price of oil perhaps there has been a huge decrease in the supply of oil maybe some oil fields have been destroyed or maybe the opec countries have got together and agreed to slash the output of oil by huge numbers and for whatever reason the price of oil goes through the roof well in this scenario there would be a huge increase in input costs so a huge increase in the cost of production for businesses and this would shift the short run aggregate supply curve to the left now a shift to the left of the short run aggregate supply curve would see a new equilibrium point right here and as we can see there has been an increase in inflation so an increase in the general level of prices of goods and services within the economy at the same time we have had a contraction in gdp so there has been a decrease in economic growth and any time as we know by now we are operating below full employment output so an actual output is lower than potential output in an economy this creates a negative output gap so you can already see that a stagflationary scenario is pretty bad for the economy in general because we have a negative output gap because of this we have an increase in the level of unemployment inflation actually increases this is cost push inflation so this is not a desirable type of inflation because now at the same time as a higher level of unemployment so people are out of work their costs of living are increasing and not only are the costs of living increasing for people in the domestic economy while growth has stagnated or decreased this also has a negative effect on the trade balance as exports become less competitive in a stagflationary scenario ceteris paribus of course not taking into account any self-adjustments in the exchange rate so all other things being equal this is negative for the trade balance

so any shift below long-run aggregate supply is unsustainable in the long term and we would expect the economy to self-heal back to long-run aggregate supply equilibrium so back to the full employment level of output now why would this take place well because when the economy is performing below its potential outputs level creating a negative output gap unemployment will increase as there is less output there is less business less production taking place so there is less need for workers and this increase in unemployment leads to an abundance of labor so although in the short run wages rent and contracts may be fixed even though output has contracted in the long run this abundance of labor will start to feed into the labor market and what will happen is wage expectations rent expectations and even contract expectations will be revised down and revisions to the downside in wages rent and contracts will lower the cost of production for business and this will shift short run aggregate supply back to the right and back to long run equilibrium