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Lesson 12: GDP Formula & Shifts in Aggregate Demand & Supply

Module 1: Macro Fundamental Analysis

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Video Transcript

In this lesson we’re going to explore further why the aggregates demand curve is downward sloping and the effects that this has on consumption investment government spending net exports when we have changes to the price level so we touched on this before this is just the same as what we looked at in previous videos we have our downward sloping aggregate demand curve and as we also discussed previously it is downward sloping because as the average level of prices so the average price of goods and services within an economy declines so deflation there is an extension there is a shift to the right along the aggregate demand curve so we’re not talking about shifting of the entire curve we’re talking about price points along the curve shift to the right when there is a reduction in prices and when there is an increase so when there is inflation an increase in the average level of prices of goods and services within the economy we see a shift to the left there is a contraction in demand total demand within that economy as prices rise and this is because as we discussed before one of the reasons is that bargain mentality as prices go up less people are prepared to purchase goods and services at higher prices as prices come down more people are prepared to purchase goods and services at slower prices and remember when we’re talking about shifts along the aggregate demand curve it’s a chicken and egg scenario so what came first what comes first is the change in prices because if you have economic growth if you have strong economic growth this is actually inflationary you would expect with a strong economic performance and increases in GDP prices to be bid up but what we’re talking about here when we’re talking about shifts along the curve is what happens if there is a reduction in prices first or an increase in the general level of prices within that economy first what are the knock-on effects of those changes in the average price level of goods and services so that’s an important thing to understand when you’re talking about shifts along the aggregate demand curve so the three factors in shifts along the aggregate demand curve so shift to the left as prices rise a contraction of demand or a shift to the right an expansion or an extension of demand as prices come down the three major factors behind those increases and decreases in demand as is linked to changes in the price level are firstly the wealth effect so the wealth effect states that ceteris paribus so all other things being equal as an assumption there if the price level decreases people become relatively more wealthy in real terms so that terminology real terms so adjusted for inflation they become wealthier and this is because their purchasing power increases because now if you’ve got a hundred dollars in the bank you can buy more goods and services with that hundred dollars because goods and services are cheaper so you’re relatively better off when you adjust for inflation so changes in the price level and this in turn will increase spending and consumption so consumption goes up when price is gone down it’s that sale mentality this is why businesses offer sales because even by offering their products for less they can actually generate more money because consumption increases at lower prices so this increases the value of the c components in GDP formula this is expansionary and increases aggregate demand so real GDP and remember aggregate demand can only change with changes to consumption investment government spending or net exports so the second factor which shifts aggregates demand within an economy purely based on changes in price level so expansions and contractions along the curve is the interest rate effect so this is the second primary reason why the aggregate demand curve slopes downwards ceteris paribus so all things being equal when the average level of prices of goods and services within an economy decreases comes down interest rates will decrease to manage deflation so central banks around the world as the average price of goods and services within their economy start to decline or there is deflation they will lower interest rates in order to stimulate demand or if inflation is getting too high which we’ll come on to later on they will actually increase interest rates to stop inflation from getting too high above that generally speaking two percent band so a reduction in prices of goods and services within an economy means interest rates ceteris paribus will remain low this causes consumers and businesses to borrow more money to spend and invest so this affects the c and the i components of aggregate demand so spending and investing consumption and investment goes up lower interest rates also cause the domestic exchange rate to fall and this makes exports relatively cheaper again ceteris paribus so if everything else remains the same and this increases the value of the c i and x minus m components in the GDP formula so an increase in borrowing to consume and spend is the c and the i and the x minus m is the domestic exchange rate in with lower interest rate levels so money comes out of that country into higher yielding currencies for example so there is more supply of that currency the value of that currency declines and this makes exports relatively cheaper increasing the GDP formula by increasing the nx component over here so you can see one plus one plus one plus one and this is all in dollar terms so one dollar equals four dollars if we were just to change this to two and we would change investments to and we would change nx to two you can see this has a positive effect on overall GDP in terms of dollar amounts so seven dollars and this increase here in GDP is reflected by a shift to the right isn’t it because if you start here let’s say and your output is 600 in terms of real GDP and you shift to the right and you come to this level here it is now 800 so you’ve had an increase of 200 in GDP it’s reflecting exactly what we’ve looked at here so we shift to the right aggregate demand increases because of increases to these components real GDP also increases and finally the third factor which shifts aggregates demand along the aggregate demand curve so price points along the curve is the trade effect and this affects the x minus m component here of the GDP formula so etc as power of us all things being equal when the average level of prices of goods and services within an economy decreases exports become more competitive and imports become less competitive so what this means is that the x components will actually increase you will increase your exports because they are now cheaper and the m component will actually decrease because imports become less competitive people start to buy domestically so people who may have imported a product will now actually prefer to purchase that product domestically because it’s cheaper so this causes an increase in demand for exports and decrease in demand for imports this increases the value of the nx component in the GDP formula so right here and we’re talking about values again so yes the value the price of exports may have come down but it will stimulate enough demand to actually increase overall revenue from those exports so the x number the nx value here will still increase let’s say this increases to four and you can see as this increases to four as net exports increase this is expansionary increases aggregate demand aggregate demand goes up a shift to the right shifts us to the right along the curve and we’re shifting to the right purely because of changes to the price level if we now just shift along

You can simply see that on the right hand side here we just have the opposite of what we’ve discussed so ceteris paribus if the price level increases people become relatively less wealthy in real terms their purchasing power decreases this in turn will decrease spending and consumption this decreases the c component of the GDP formula so in terms of aggregate demand this will be a shift to the left it will decrease

This is contractionary and decreases aggregates demand so if consumption decreases because people have become relatively less wealthy you can see real GDP will also decrease ceteris paribus when the price level increases interest rates will increase to manage inflation so if the price level of goods and services within the economy starts to become too high central banks will step in and raise interest rates to stop inflation from getting out of hand this causes consumers and businesses to borrow less money because now it costs more to borrow because interest rates are higher so you have to pay back more money you have higher repayments because of an increase in interest rates and this also causes the domestic exchange rate to rise making exports relatively more expensive this decreases the value of the ci and xm components in the GDP formula so a decrease in these components will reduce gdp this will be a shift to the left once again in aggregate demand aggregate demand will contract because of a change because of a rise in prices of goods and services within that economy and finally the trade effect ceteris paribus when the price level increases exports become less competitive and imports become more competitive so now opposite to what we discussed over here domestic consumers may actually start to import more because prices domestically have gone up and they can actually get services or products cheaper in another country so this causes a decrease in demand for exports and an increase in demand for imports and this negatively affects the nx components of the GDP formula this is contractionary and decreases aggregate demand and therefore real GDP once again shifting along the ad curve to the left so a contraction in aggregate demand so in the previous tab we looked at how changes to the average level of prices of goods and service within the economy can shift aggregates demand either extending it along the curve or contracting it and either therefore increasing GDP or contracting GDP and in the next few videos we’re going to be looking at reasons why the whole curve will shift and these are non-price related factors so increases or decreases in aggregate demand total demand for an economy’s goods or services but not because of changes to the price of those goods and services so this is really just a simple tab here because this reaffirms what we’ve already discussed there’s nothing new that we’re looking at on here to what we’ve discussed in previous videos if consumption goes up for reasons which are not related to price this will shift the aggregate demand curve to the right and real GDP will increase so consumption increases because of reasons not linked to price real GDP increases the aggregate demand curve shifts to the right if consumption decreases real GDP also decreases and this will shift aggregate demand to the left if investment increases for reasons not linked to changes in the prices of goods and services within an economy this will shift the aggregate demand curve to the right investment increases once again real GDP increases if investment decreases in an economy for reasons not linked to the prices of goods and services within that economy you can see real GDP will once again decrease this will be a shift to the left of the entire curve if government spending increases within an economy so this is on the fiscal side fiscal measures taken by governments this will shift the ad curve to the right and we will see an increase in real GDP

If government spending decreases if there is a decrease in the levels of government spending within an economy this will shift the ad curve to the left in its entirety and this will decrease GDP this will have a negative effect on growth if net exports increase so an economy becomes more of a net exporter this will shift aggregate demand to the right and the whole curve will shift to the right and this will increase real GDP

and as we’ve seen in previous videos also will increase inflation and conversely if a country becomes more of a net importer so net exports decrease this will shift the entire curve to the left once again assuming that decreasing net exports has nothing to do with the price of those exports and this will see a contraction in real GDP so again really this tab is for future reference just to come back to if you want to clarify how shifts in the curve affect GDP nothing we haven’t discussed before this is just all in one tab for you so you can come and reference this whenever you like if you want to refresh your memory on shifts in the curve itself