106 Learning Module 3 Aggregate Output, Prices, and Economic Growth

2. Oil prices rising from around US$30 a barrel in 2004 to nearly US$150 a
barrel in 2008. (Note that most Asian economies rely on imports for almost
all of their oil and energy needs. In contrast, the United States has a large
domestic energy industry and imports only about half of its oil.)

Solution to 2:
e rise in oil prices increased input cost and shifted the short-run AS curve
to the left. Because the eastern Asian economies depend heavily on import-
ed oil, their economies were more adversely a ected than that of the United
States.

3. e dramatic reduction in credit availability following the collapse or near

collapse of major nancial institutions in 2008.

Solution to 3:
e decline in housing prices caused nancial institutions in the United
States to su er large losses on housing-related loans and securities. Sev-
eral large lenders collapsed, and the US Treasury and the Federal Reserve
had to intervene to prevent a wave of bankruptcies among large nancial
institutions. As a result of the crisis, it became di cult for households and
businesses to obtain credit to nance their spending. is dynamic caused
AD to fall and increased the severity of the recession in the United States,
resulting in a signi cant decline in US imports and thus exports from the
Asian economies. In addition, the nancial crisis made it more di cult to
obtain trade nance, further reducing exports from Asia.
In summary, global investors need to be aware of the growing linkages
among economies and the extent that one economy’s growth depends on
demand from within as well as from outside of that economy. Data on
exports as a percentage of an economy’s GDP provide an indication of this
dependence. Although Japan is often viewed as an export-driven economy,
Exhibit 20 shows that in 2018, exports were only 18% of its GDP. Similarly,
the economy of India depends largely on domestic spending for growth
because in 2018, exports accounted for only 20% of GDP.

In ationary Gap
Increases in AD lead to economic expansions as real GDP and employment increase. If
the expansion drives the economy beyond its production capacity, however, in ation
will occur. e in ation rate is de ned as the increase in the general price level from
one period to the next. As summarized in Exhibit 14, higher government spending,
lower taxes, a more optimistic outlook among consumers and businesses, a weaker
domestic currency, rising equity and housing prices, and an increase in the money
supply would each stimulate aggregate demand and shift the AD curve to the right. If
aggregate supply does not increase to match the increase in AD, a rise in the overall
level of prices will result.
As shown in Exhibit 20, an increase in AD will shift the equilibrium level of GDP
from Point A to Point B. Real output increases from Y1 to Y2, and the aggregate price
level rises from P1 to P2. As a result of the increase in aggregate demand, companies
increase their production and hire more workers. e unemployment rate declines.
Once an economy reaches its potential GDP, however, companies must pay higher
wages and other input prices to further increase production. e economy now faces
Aggregate Demand and Aggregate Supply 107

an in ationary gap, measured by the di erence between Y2 andY1 in Exhibit 20. An

in ationary gap occurs when the economy’s short-run level of equilibrium GDP is above
potential GDP, resulting in upward pressure on prices.

Exhibit 20: In ationary Gap

Price LRAS SRAS2

Level
C SRAS1
P3

P2 B

P1 A

AD2

AD1

Y1 Y2 Income, Output, Y
Y3

GDP cannot remain at Y2 for long because the economy is overutilizing its resources—
that is, extra shifts of workers are hired and plant and equipment are operating at
their maximum capacity. Eventually, workers become tired and plants and equipment
wear out. e increase in the general price level and input prices will set in motion
the process of returning the economy back to potential GDP. Higher wages and input
prices shift the SRAS curve to the left (from SRAS1 to SRAS2), moving the economy
to Point C in Exhibit 20. Again, this self-correcting mechanism may work slowly.
A nation’s government and/or its central bank can attempt to use the tools of scal
and monetary policy to control in ation by shifting the AD curve to the left (AD2 to
AD1 in Exhibit 20) so that the return to full employment occurs without the price
increase. From a scal perspective, policymakers can raise taxes or cut government
spending. From a monetary perspective, the central bank can reduce bank reserves,
resulting in a decrease in the growth of the money supply and higher interest rates.

Investment Implications of an Increase in AD Resulting in an In ationary Gap

If economic statistics (consumer sentiment, factory orders for durable and nondura-
ble goods, etc.) suggest that there is an expansion caused by an increase in AD, the
following conditions are likely to occur:
■ Corporate pro ts will rise.
■ Commodity prices will increase.
■ Interest rates will rise.
■ In ationary pressures will build.
is situation suggests the following investment strategy:
■ Increase investment in cyclical companies because they are expected to have
the largest increase in earnings.
■ Reduce investments in defensive companies because they are expected to
have only a modest increase in earnings.
108 Learning Module 3 Aggregate Output, Prices, and Economic Growth

■ Increase investments in commodities and commodity-oriented equities

because they will bene t from higher production and output.
■ Reduce investments in xed-income securities, especially longer-maturity
securities, because they will decline in price as interest rates rise. Raise
exposure to speculative xed-income securities (junk bonds) because default
risks decrease in an economic expansion.

Stag ation: Both High In ation and High Unemployment

Structural uctuations in real GDP are caused by uctuations in SRAS. Declines in
aggregate supply bring about stag ation—high unemployment and increased in a-
tion. Increases in aggregate supply conversely give rise to high economic growth and
low in ation.
Exhibit 21 shows the case of a decline in aggregate supply, perhaps caused by an
unexpected increase in basic material and oil prices. e equilibrium level of GDP
shifts from Point A to B. e economy experiences a recession as GDP falls from Y1
to Y2, but the price level, instead of falling, rises from P1 to P2. Over time, the reduc-
tion in output and employment should put downward pressure on wages and input
prices and shift the SRAS curve back to the right, re-establishing full employment
equilibrium at Point A. However, this mechanism may be painfully slow. Policymakers
may use scal and monetary policy to shift the AD curve to the right, as previously
discussed, but at the cost of a permanently higher price level at Point C.

Exhibit 21: Stag ation

Price LRAS
Level SRAS2
C
SRAS1

P2 B
P1 A

AD

Y2 Y1 Income, Output, Y

e global economy experienced stag ation in the mid-1970s and early 1980s. Both
unemployment and in ation soared. e problem was caused by a sharp decline in
aggregate supply fueled by higher input prices, especially the price of oil. In 1973, the
price of oil quadrupled. A steep global recession began in late 1973 and lasted through
early 1975. e recession was unusual because prices rose rather than declined as
would be expected in a typical demand-caused downturn. In 1979–1980, the price of oil
doubled. Higher energy prices shifted the SRAS curve to the left, as shown in Exhibit
21, leading to a global recession in 1980–1982. In the United States, the contraction
in output was reinforced by the Federal Reserve’s decision to tighten monetary policy
to ght the supply-induced in ation.
Aggregate Demand and Aggregate Supply 109

Investment Implications of a Shift in AS

Labor and raw material costs, including energy prices, determine the direction of
shifts in short-run aggregate supply: Higher costs for labor, raw materials, and energy
lead to a decrease in aggregate supply, resulting in lower economic growth and higher
prices. Conversely, lower labor costs, raw material prices, and energy prices lead to an
increase in aggregate supply, resulting in higher economic growth and a lower aggre-
gate price level. Productivity is also an important factor. Higher rates of productivity
growth shift the AS to the right, resulting in higher output and lower unit input prices.
Lower rates of productivity growth do the opposite and shift the AS curve to the left.
From an investment perspective, a decline in AS (leftward shift of the SRAS curve)
suggests:
■ reducing investment in xed income because rising output prices (i.e., in a-
tion) put upward pressure on nominal interest rates,
■ reducing investment in most equity securities because pro t margins are
squeezed and output declines, and
■ increasing investment in commodities or commodity-based companies
because prices and pro ts are likely to rise.
On the other hand, an increase in AS (rightward shift of the SRAS curve) result-
ing from higher productivity growth or lower labor, raw material, and energy costs is
favorable for most asset classes other than commodities.

Conclusions on AD and AS
e business cycle and the resulting uctuations in real GDP are caused by shifts
in the AD and AS curves. e e ects of these shifts can be summarized as follows:
■ An increase in AD raises real GDP, lowers the unemployment rate, and
increases the aggregate level of prices.
■ A decrease in AD lowers real GDP, increases the unemployment rate, and
decreases the aggregate level of prices.
■ An increase in AS raises real GDP, lowers the unemployment rate, and low-
ers the aggregate level of prices.
■ A decrease in AS lowers real GDP, raises the unemployment rate, and raises
the aggregate level of prices.
Whether the growth of the economy is demand- or supply-driven has an e ect
on asset prices. Demand-driven expansions are normally associated with rising
interest rates and in ation, whereas contractions are associated with lower in ation
and interest rates. Supply-driven expansions are associated with lower in ation and
interest rates, whereas supply-driven contractions are associated with rising in ation
and interest rates.

EXAMPLE 10

Investment Strategy Based on AD and AS Curves

An analyst is evaluating the possibility of investing in China, Italy, Mexico, or
Brazil. What are the equity and xed-income investment opportunities in these
countries based on the following events?