Now that we understand why the aggregate demand curve slopes downward, let's look much more closely at why and how, the aggregate demand curve can shift. From the perspective of business executives and investors seeking to forecast the economy, this is a very important question. Consider for example, this figure. Here you can see an outward shift of the aggregate demand curve from AD to AD star. What happens to the price level as a result of this shift? What's the new level of real GDP output? Jot down your answer before moving on please. You can see in the figure, that this outward shift of the AD curve results in an increase in the price level to P star in the new equilibrium. You can also see that real GDP rises to Q star. In other words, you get more growth, but you also get more inflation. Thus a business executive or investor that anticipates an outward shift of the aggregate demand curve will be more bullish about the economy and stock market, but also more vigilant in about the dangers of rising inflation. The question of course is, what are the major factors that might shift the aggregate demand curve inward in a recessionary and deflationary direction, or outward in an expansionary but inflationary direction? This figure provides a sample list grouped by the four major growth drivers in our GDP forecasting equation. For example, a change in either consumer wealth or expectations can lead to a change in consumer spending that ripples through to a change in the real GDP growth rate. Similarly, a change in interest rates or business taxes, can affect investment spending. As for government spending, a change in the direction of fiscal policy can affect that, just as a change in the political control of a government can influence spending patterns. For example, conservative governments tend to reduce government spending, while liberal governments tend to increase it. Finally, net exports can certainly be affected by changes in exchange rates. We'll talk a lot more about exchange rates in a future lesson. But robust growth in other countries can also lead to more demand for the domestic country's exports as well. So take a minute to study this figure carefully and then let's have a little bit of fun working our way through some possible real world scenarios that illustrate shifts in the aggregate demand curve. In this morning's newspaper, the digital version of course, you read that a sustained increase in productivity brought about by technological change is leading to a rise in consumer wealth. At the same time, the latest report on consumer confidence indicates a rise in confidence about future economic conditions. So how would you represent this news in the aggregate demand, aggregate supply model? Take a minute now to draw your answer. Here you can see that an increase in wealth and an improvement in consumer expectations, would both lead to a shift in the AD curve. And news like that is usually very bullish for executives and investors. Now what about this? You are a business executive in Japan and you read that the Japanese Central Bank has increased interest rates by 50 basis points. That's one half of one percent. You also read that on the same day the Japanese Diet, that's Japan's equivalent of the U.S. Congress or British Parliament, has voted to cut, cut consumer taxes by 15 percent. Is this news of the day bullish or bearish and how would you represent this in the aggregate supply, aggregate demand model? Take a minute now to think about that and jot down or draw your answer. Okay, I'm not a big fan of trick questions, but I had to use this one in this case to make an important point. The trick part of the question here is that the two factors I noted, an interest rate hike and a tax cut will move the aggregate demand curve in opposite directions. For example, a rise in interest rates will shift the A_D curve in. This could be bearish because higher interest rates will discourage business investment. However, a tax cut will drive the aggregate demand curve out. And that will be bullish because the tax cut will give consumers more purchasing power. So, what's the net effect of these two opposing forces? Well, that's the tricky part because it is often impossible to know. So here's the broader key point. In cases like this, as a business executive or investor, you won't always know the net effect of several competing changes in the macro economy. In this particular case it would be difficult to know without more information, whether the interest rate or tax cut effect would dominate. And in such cases, this will cause more uncertainty in your forecast. Something very important to note. Now, let's do one last example here related to the net export component of the GDP equation. Okay, suppose you are a hedge fund manager with a billion dollars to invest globally. Your specialty is using so-called, Exchange Traded Funds or ETFs to invest in specific countries, based on opportunity and risk. And here note this key definition of an exchange traded fund. An ETF, or Exchange Traded Fund, typically tracks an index, like the S&P 500 stock market index. A commodity such as oil, long or short term bond portfolios and other assets like real estate. The beauty of Exchange Traded Funds or ETFs, is that they can be traded just like stocks. And there are ETFs you can invest in for stock markets of countries around the world, from Germany and Great Britain to China, Japan and even New Zealand. Suppose that you in your role as a hedge fund manager, read in the news that in response to a steep and prolonged recession, the American government and its central bank of the Federal Reserve embarks on an aggressive policy of Quantitative Easing. And note that Quantitative Easing is a form of monetary policy that involves buying long term government bonds with newly printed money. Of course, the goal of Quantitative Easing is to drive down long term interest rates to stimulate growth. Here's what I call the money question. Would you as a hedge fund manager, be more or less inclined to invest in New Zealand for your hedge fund portfolio once the U.S. Federal Reserve begins its aggressive policy of quantitative easing? And note that in thinking about your answer, New Zealand is a country that depends heavily on exports, in its GDP equation for its growth. So do think about this intriguing money question for a minute, which may seem a bit strange at first, but then jot down your answer before moving on. In fact, this question is not strange at all, just a bit complicated in a fun kind of way. And the answer is this, as a hedge fund manager you should definitely not buy the New Zealand Exchange Traded Fund. Here's why and see if this is the same answer that you get. If America embarks on a policy of loose monetary policy, this will drive down U.S. interest rates on long term bonds. Lower American interest rates will in turn drive down the value of the U.S. dollar relative to other currencies like New Zealand's dollar. And note that the US dollar will fall because of fall in interest rates and America, will make foreign investment in the US less attractive, so there will be less demand for dollars. As for the rise in New Zealand's exchange rate, a stronger currency will make it harder for New Zealand dairy farmers to sell their exports. The result will be a fall in net exports as indicated by an inward shift of New Zealand's aggregate demand curve. Of course, this causes a fall in real GDP and with lower profits in the New Zealand economy, New Zealand's stock market falls along with the New Zealand ETF. You definitely don't want to be investing in New Zealand in this quantitative easing scenario. So take a minute now to study this figure very carefully and be sure you understand every single step along the way. When you are finished, let's move on to the next and final module of this lesson.
