Hello everyone, in this video we are going to learn about another model which is Aggregate Demand and Aggregate Supply. To understand this model, first we need to see how we define Aggregate Demand. Aggregate Demand is basically in the entire economy, when you keep everything else constant, the amount of real GDP that all the buyers together can purchase collectively, that's what we show it as Aggregate Demand. When we say all the buyer groups in the economy, as we have seen for aggregate expenditure model, we are going to talk about again those four groups.
One is consumer group, second is investment that comes from the firms, firms is another group, then comes the government, then comes the foreign sector. If you include all those groups, then aggregate demand looks similar to aggregate expenditure, which is consumption plus gross investment. plus government purchases and net exports. Okay, so consumer spending represented by C, investment spending represented by IG, government spending represented by G, and finally, foreign sector spending, which we call it as net exports represented by X. Now, when you include all those things, what we show is aggregate demand.
We take price level on the vertical axis. Simply, you can put it as prices or... price level because this is entire economies price level and on the horizontal axis we take real GDP purchased are demanded or you can leave it at leave it as real GDP as well so if you look at this curve it's going to go something like this this is what aggregate demand and this will represent basically what you have all these four things now what we want to understand is why this relationship is negative in other words why price level and real GDP purchased are downward sloping okay so that negative relationship comes from importantly three different reasons first reason we talk about real balance effect real balance effect means simply when price level changes the real demand real GDP demanded is going to change because of the purchasing power of the money is going to change that means when price level increases purchasing power of money decreases that makes us purchase less amount of real GDP. So that itself explains the negative effect. When price level changes, change in the real GDP demanded due to change in purchasing power of fixed amount of money.
We put it as real balance effect. Just to be clear, since price level goes up, the amount of money that we have which is fixed, the purchasing power of that amount decreases when purchasing power decreases the real GDP demanded also decreases that's what gives the negative relationship second type of effect we call it as interest rate effect interest rate effect is basically change in the real GDP due to change in the interest rate change in the interest rate due to price level change okay so simply you can put it as how much real GDP demanded depends on change in the interest rate when the price level changes. Simply speaking, when price level increases, we need more money to purchase the same amount of goods.
If you need more amount of money, that means the demand for money increases, that will cause interest rate to increase. If interest rate increases, we'll see consumption to decrease. So in terms of breaking down into the points, when price level increases, we need more money to purchase the same amount of goods.
So First point you want to note it here is supply of money. Okay, so two ways to put it. Supply of money is basically, sorry, demand for money is basically increasing because we need more money to purchase the same amount of goods. Okay, so higher the demand for money means higher the interest rate. Interest rate is basically price of money.
Okay, so it sounds a little off, but price of money is represented by interest rate. So higher the demand for money. means higher the price of money, in other words, higher interest rate. When you have higher interest rate, consumption actually decreases because when you have to borrow money and consuming, the cost of borrowing increases.
Cost of borrowing increases means consumption increases. It can decrease investment as well. So reduction in consumption basically leads to reduction in the amount of real GDP.
That comes as the second factor. for the reason for aggregate demand to be downward sloping. Now let's look at the third one. Third one we call it as foreign purchase effect.
Anytime price level changes, we kind of use the foreign goods or foreign produced goods as a substitute. So when prices of domestic goods increases, we kind of shift towards the goods that are produced outside the United States. That means the real GDP demanded that is produced within the United States starts to decrease.
So you can consider these three factors. for downward sloping aggregate demand curve. Now we want to look at when does okay so just not the demand curve downward sloping but we also need to focus on when can demand curve actually shift that means this is price level this is real GDP on the horizontal axis or aggregate output you have aggregate demand something like this this is aggregate demand this aggregate demand can either increase or aggregate demand can also decrease.
want to understand what can cause aggregate demand to increase or decrease. Those are the things that we call it as determinants of aggregate demand. In other words, factors causing shift in aggregate demand. Now, if you look at the aggregate demands, it is represented by addition of all the four factors.
Okay, so purchasing of all people, that's what we show it as aggregate demand here, which includes consumption, investment, government spending, and also net exports. That means any time any one of these factors changes or any factor that is influencing either consumption or investment or government purchases or net exports can also change aggregate demand. If you can put those things together, first we'll start with the consumption factors.
So what are the consumption factors that can change consumption? When consumption changes, how it's going to change? aggregate demand.
So these are determinants of aggregate demand but coming from the change in consumption or consumption factors. First important one we call it as wealth effect. Okay so wealth is basically assets minus liabilities. Any time suddenly received or accumulated wealth change can actually change the consumption and consumption changes that will change the aggregate demand.
Okay so if it is a positive effect aggregate demand goes to the right if it is negative effect aggregate demand goes to the left. So now what is received wealth? Because wealth is not same as income. Don't confuse with that one. Wealth is different.
Simple way to look at is focus on the assets part of it. So people have assets such as real estate or even stock market. What happens?
Let's say stock market suddenly crashes. That means you hold stocks as your assets. Suddenly stock market crashing. That means your value of assets actually decreasing. When value of assets decreases, the wealth decreases.
That will have the effect on consumer spending. People suddenly feel less wealthy compared to yesterday and they start to spend less. If that's the case, you can expect consumption actually decreases. When consumption decreases, you'll expect aggregate demand to decrease.
In other words, if you have aggregate demand like this, it will be going backwards. That's what we show it as first type of effect. Now, second thing that we look at is borrowing.
Ability to borrow increases present consumption, which leads to upward shift in aggregate demand. In other words, it causes going to the right. So if people have more ability to borrow, whichever the reasons that causes borrowing, that leads to increase in consumption, aggregate demand to increase and vice versa.
The consumption borrowing also depends on the interest rates. Interest rates play an important role in terms of how much amount you can borrow. So lower these rates means more borrowing, more borrowing means more present consumption, more present consumption means and also you can see investment to increase. If consumption and investment both increasing, you can see aggregate demand curve shifting upwards or going towards right. Next factor, also consumption factor expectations and consumers expect their future income to be higher.
They'll start spending more today. Same thing, if they expect future prices to be higher, they'll spend more today because they want to purchase before the prices to increase. That will cause aggregate demand to increase. Next factor that also causes investment to change is personal taxes. Okay, so when the personal taxes increases, disposable income actually decreases.
Disposable income decreasing. When personal taxes increases, disposable income actually... decreases when disposable income decreases consumption decreases that will cause aggregate demand to decrease that comes as another reason for aggregate demand to decrease After these factors, what we want to look at is other than consumption, investment can also change the aggregate demand.
We want to focus on factors that is influencing the investment, investment factors. All the factors that cost shift in ERR. You guys remember ERR basically represents expected rate of returns.
So anytime expected rate of returns changes, that will change the investment. when investment changes aggregate demand will move in the same direction so looking at the factors that will change expected rate of returns first factor that comes is a change in operating cost as operating cost increases expected rate of return which decreases that will cause aggregate demand curve to shift to the left or decrease either ways you can say and exactly opposite is true if operating costs are lower you can expect more expected rate of returns. Correctly speaking, expected rate of returns is basically revenue, what you are getting, minus cost over cost. That's what gives the expected rate of return. Anytime, if you can actually reduce the cost, that's what is the operating cost here.
That means the profit, which is revenue minus cost, actually increases. That will cause expected rate of returns to increase and vice versa is true. Unfortunately, if the operating cost actually increases, profits decrease and rate of returns actually starts to decrease as well.
Second thing that influences the cost that will influence expected rate of returns is business taxes. When business taxes increases, cost increases as you see in this formula. That will cause expected rate of returns to decrease and aggregate demand actually shifts to the left.
Next factor is business expectations. So there are optimistic as well as pessimistic expectations. If we expect business is going to be fine in the future, more business is going to come.
That means investment is easier. Expected rate of returns looks bigger because expected revenue looks bigger. Then that will cause aggregate demand to shift to the right.
Other than that, we also focus on existing capital, stock of existing capital or excess capacity. If we have too much excess capacity, investing more. actually not going to give you extra revenue.
So that means expected rate of returns will be lower. That will cause aggregate demand curve to shift to the left. The other factors that come is from time to time, the technology you are using can change.
When technology changes, you have to purchase new machinery. On that new machinery, the expected rate of returns could be higher. Technological changes leads to increase in expected rate of returns, causing aggregate demand to shift to the right. Now, other than consumption and investment we also have government purchases this is simply fiscal policy part increase in government spending simply causes increase in aggregate demand last thing that causes change in aggregate demand is net exports net exports is simply exports minus imports any time any factor that can influence either exports or impl imports can can have a positive effect onto the aggregate demand so that means If exports increases, aggregate demand will increase.
But if imports increases, net exports will decrease. Aggregate demand is going to go to the left. So what factors can influence exports here?
So net exports factor first one, we call it as national income abroad. So that means the nations where we are sending our exports, if they are doing really well, their demand for goods increases, which includes the goods that we are exporting as well. So. our exports increases that will cause aggregate demand to shift to the right. Second factor is exchange rate.
If dollar appreciates compared to other currencies, U.S. goods looks expensive. So our exports will decrease that will cause net exports to decrease and exactly vice versa is true. If dollar depreciates, dollar depreciates that means U.S. goods looks cheaper and for U.S. consumers the foreign goods looks cheaper.
actually expensive. In that case, we'll import less, export more, aggregate demand actually starts to increase. Last one, you must have seen this in the debates a lot of times, comes tariffs.
Suppose if a US imposing a lot of tariffs on imported goods, what you can expect is immediately net exports could be increasing. So, but I want you to pay attention here, the factor that you are seeing is a short term effect. Okay. So What we see in the short run is net exports to increase and aggregate demand could increase.
But if you actually see the studies in the long run, it can have a negative effect as well. So what happens? Why will we have negative effect in the long run? Simple thing, when you increase the tariffs, initially, sure, we may be able to export more or import less. But the problem is eventually other nations in retaliation, they may increase their tariffs as well, or they may want to import less of our goods.
That means our exports is going to decrease. If that's the case, you can have a negative effect on aggregate demand. So as you can see, there is lot of factors that comes into place anytime you take a single factor first you have to see what is influencing uh is it c g r i g or xn then you have to see how does that influence finally going to affect aggregate demand