MacroeconomicsScience and Technology
Shifts in Aggregate Demand
As mentioned previously, the components of aggregate demand are consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M). (Read the following Clear It Up feature for explanation of why imports are subtracted from exports and what this means for aggregate demand.) A shift of the AD curve to the right means that at least one of these components increased so that a greater amount of total spending would occur at every price level. A shift of the AD curve to the left means that at least one of these components decreased so that a lesser amount of total spending would occur at every price level. The Keynesian Perspective will discuss the components of aggregate demand and the factors that affect them. Here, the discussion will sketch two broad categories that could cause AD curves to shift: changes in the behavior of consumers or firms and changes in government tax or spending policy.
We have seen that the formula for aggregate demand is AD = C + I + G + X – M, where M is the total value of exported goods. Why is there a minus sign in front of imports? Does this mean that more imports will result in a lower level of aggregate demand?
Actually, imports are already included in the formula in the form of consumption (C). When an American consumer buys a foreign product, it gets counted along with all other consumption. Since the income generated does not go to American producers, but rather to producers in another country, it would be wrong to count this as part of domestic demand. Therefore, imports added in consumption are subtracted back out in the M term of the equation.
Because of the way in which the demand equation is written, it is easy to make the mistake of thinking that imports are bad for the economy. Just keep in mind that every negative number in the M term has a corresponding positive number in the C term, and they always cancel out.
How Changes by Consumers and Firms Can Affect AD
When consumers feel more confident about the future of the economy, they tend to consume more. If business confidence is high, then firms tend to spend more on investment, believing that the future payoff from that investment will be substantial. Conversely, if consumer or business confidence drops, then consumption and investment spending decline.
The Conference Board, a business-funded research organization, carries out national surveys of consumers and executives to gauge their degree of optimism about the near-term future economy. The Conference Board asks a number of questions about how consumers and business executives perceive the economy and then combines the answers into an overall measure of confidence, rather like creating an index number to represent the price level from a variety of individual prices. For consumer confidence, the overall level of confidence in 1985 is used as a base year and set equal to 100, and confidence in every other year can be compared to that base year. Measured on this scale, for example, consumer confidence rose from 100 in August 2006 to 111 in February 2007, but had plummeted to 56 by early 2010.
Business confidence is measured on a scale from 0 to 100, so that a score of 50 represents a neutral view, 100 would represent extreme confidence, and 0 would represent an extreme lack of confidence. Business confidence sank from 57 in the first quarter of 2006 to 44 in the third quarter of 2006 before rebounding to 53 in the first quarter of 2007. It sank as low as 35 in early 2009 before bouncing back to 58 by early 2010. Of course such survey measures are not precise. They can, however, suggest when confidence is rising or falling, or when it is relatively high or low compared to the past.
Because a rise in confidence is associated with higher consumption and investment demand, it will lead to an outward shift in the AD curve, and a move of the equilibrium, from E0 to E1, to a higher quantity of output and a higher price level, as shown in [link] (a).
Consumer and business confidence often reflect macroeconomic realities; for example, confidence is usually high when the economy is growing briskly and low during a recession. However, economic confidence can sometimes rise or fall for reasons that do not have a close connection to the immediate economy, like a risk of war, election results, foreign policy events, or a pessimistic prediction about the future by a prominent public figure. U.S. presidents, for example, must be careful in their public pronouncements about the economy. If they offer economic pessimism, they risk provoking a decline in confidence that reduces consumption and investment and shifts AD to the left, and in a self-fulfilling prophecy, contributes to causing the recession that the president warned against in the first place. A shift of AD to the left, and the corresponding movement of the equilibrium, from E0 to E1, to a lower quantity of output and a lower price level, is shown in [link] (b).
How Government Macroeconomic Policy Choices Can Shift AD
Government spending is one component of AD. Thus, higher government spending will cause AD to shift to the right, as in [link] (a), while lower government spending will cause AD to shift to the left, as in [link] (b). For example, U.S. government spending declined by 3.6% of GDP during the 1990s, from 22.2% of GDP in 1992 to 18.6% of GDP in 1999. However, from 2008 to 2009, U.S. government spending increased from 20.7% of GDP to 24.7% of GDP. If changes of a few percentage points of GDP seem small to you, remember that since GDP exceeded $14 trillion in 2009, a seemingly small change of 1.0% of GDP in annual spending is equal to more than $140 billion.
Tax policy can affect consumption and investment spending, too. Tax cuts for individuals will tend to increase consumption demand, while tax increases will tend to diminish it. Tax policy can also pump up investment demand by offering lower tax rates for corporations or tax reductions that benefit specific kinds of investment. Shifting C or I will shift the AD curve as a whole.
During a recession, when unemployment is high and many businesses are suffering low profits or even losses, the U.S. Congress often passes tax cuts. During the recession of 2001, for example, a tax cut was enacted into law. At such times, the political rhetoric often focuses on how people going through hard times need relief from taxes. The aggregate supply and aggregate demand framework, however, offers a complementary rationale, as illustrated in [link]. The original equilibrium during a recession is at point E0, relatively far from the full employment level of output. The tax cut, by increasing consumption, shifts the AD curve to the right. At the new equilibrium (E1), real GDP rises and unemployment falls and, because in this diagram the economy has not yet reached its potential or full employment level of GDP, any rise in the price level remains muted. Read the following Clear It Up feature to consider the question of whether economists favor tax cuts or oppose them.
One of the most fundamental divisions in American politics over the last few decades has been between those who believe that the government should cut taxes substantially and those who disagree. Ronald Reagan rode into the presidency in 1980 partly because of his promise, soon carried out, to enact a substantial tax cut. George Bush lost his bid for reelection against Bill Clinton in 1992 partly because he had broken his 1988 promise: “Read my lips! No new taxes!” In the 2000 presidential election, both George W. Bush and Al Gore advocated substantial tax cuts and Bush succeeded in pushing a package of tax cuts through Congress early in 2001. Disputes over tax cuts often ignite at the state and local level as well.
What side are economists on? Do they support broad tax cuts or oppose them? The answer, unsatisfying to zealots on both sides, is that it depends. One issue is whether the tax cuts are accompanied by equally large government spending cuts. Economists differ, as does any broad cross-section of the public, on how large government spending should be and what programs might be cut back. A second issue, more relevant to the discussion in this chapter, concerns how close the economy is to the full employment level of output. In a recession, when the intersection of the AD and AS curves is far below the full employment level, tax cuts can make sense as a way of shifting AD to the right. However, when the economy is already doing extremely well, tax cuts may shift AD so far to the right as to generate inflationary pressures, with little gain to GDP.
With the AD/AS framework in mind, many economists might readily believe that the Reagan tax cuts of 1981, which took effect just after two serious recessions, were beneficial economic policy. Similarly, the Bush tax cuts of 2001 and the Obama tax cuts of 2009 were enacted during recessions. However, some of the same economists who favor tax cuts in time of recession would be much more dubious about identical tax cuts at a time the economy is performing well and cyclical unemployment is low.
The use of government spending and tax cuts can be a useful tool to affect aggregate demand and it will be discussed in greater detail in the Government Budgets and Fiscal Policy chapter and The Impacts of Government Borrowing. Other policy tools can shift the aggregate demand curve as well. For example, as discussed in the Monetary Policy and Bank Regulation chapter, the Federal Reserve can affect interest rates and the availability of credit. Higher interest rates tend to discourage borrowing and thus reduce both household spending on big-ticket items like houses and cars and investment spending by business. Conversely, lower interest rates will stimulate consumption and investment demand. Interest rates can also affect exchange rates, which in turn will have effects on the export and import components of aggregate demand.
Spelling out the details of these alternative policies and how they affect the components of aggregate demand can wait for The Keynesian Perspective chapter. Here, the key lesson is that a shift of the aggregate demand curve to the right leads to a greater real GDP and to upward pressure on the price level. Conversely, a shift of aggregate demand to the left leads to a lower real GDP and a lower price level. Whether these changes in output and price level are relatively large or relatively small, and how the change in equilibrium relates to potential GDP, depends on whether the shift in the AD curve is happening in the relatively flat or relatively steep portion of the AS curve.
Key Concepts and Summary
The AD curve will shift out as the components of aggregate demand—C, I, G, and X–M—rise. It will shift back to the left as these components fall. These factors can change because of different personal choices, like those resulting from consumer or business confidence, or from policy choices like changes in government spending and taxes. If the AD curve shifts to the right, then the equilibrium quantity of output and the price level will rise. If the AD curve shifts to the left, then the equilibrium quantity of output and the price level will fall. Whether equilibrium output changes relatively more than the price level or whether the price level changes relatively more than output is determined by where the AD curve intersects with the AS curve.
The AD/AS diagram superficially resembles the microeconomic supply and demand diagram on the surface, but in reality, what is on the horizontal and vertical axes and the underlying economic reasons for the shapes of the curves are very different. Long-term economic growth is illustrated in the AD/AS framework by a gradual shift of the aggregate supply curve to the right. A recession is illustrated when the intersection of AD and AS is substantially below potential GDP, while an expanding economy is illustrated when the intersection of AS and AD is near potential GDP.
How would a dramatic increase in the value of the stock market shift the AD curve? What effect would the shift have on the equilibrium level of GDP and the price level?
An increase in the value of the stock market would make individuals feel wealthier and thus more confident about their economic situation. This would likely cause an increase in consumer confidence leading to an increase in consumer spending, shifting the AD curve to the right. The result would be an increase in the equilibrium level of GDP and an increase in the price level.
Suppose Mexico, one of our largest trading partners and purchaser of a large quantity of our exports, goes into a recession. Use the AD/AS model to determine the likely impact on our equilibrium GDP and price level.
Since imports depend on GDP, if Mexico goes into recession, its GDP declines and so do its imports. This decline in our exports can be shown as a leftward shift in AD, leading to a decrease in our GDP and price level.
A policymaker claims that tax cuts led the economy out of a recession. Can we use the AD/AS diagram to show this?
Tax cuts increase consumer and investment spending, depending on where the tax cuts are targeted. This would shift AD to the right, so if the tax cuts occurred when the economy was in recession (and GDP was less than potential), the tax cuts would increase GDP and “lead the economy out of recession.”
Many financial analysts and economists eagerly await the press releases for the reports on the home price index and consumer confidence index. What would be the effects of a negative report on both of these? What about a positive report?
A negative report on home prices would make consumers feel like the value of their homes, which for most Americans is a major portion of their wealth, has declined. A negative report on consumer confidence would make consumers feel pessimistic about the future. Both of these would likely reduce consumer spending, shifting AD to the left, reducing GDP and the price level. A positive report on the home price index or consumer confidence would do the opposite.
Name some factors that could cause AD to shift, and say whether they would shift AD to the right or to the left.
Would a shift of AD to the right tend to make the equilibrium quantity and price level higher or lower? What about a shift of AD to the left?
Critical Thinking Questions
If households decide to save a larger portion of their income, what effect would this have on the output, employment, and price level in the short run? What about the long run?
If firms become more optimistic about the future of the economy and, at the same time, innovation in 3-D printing makes most workers more productive, what is the combined effect on output, employment, and the price-level?
If Congress cuts taxes at the same time that businesses become more pessimistic about the economy, what is the combined effect on output, the price level, and employment using the AD/AS diagram?
The Conference Board, Inc. “Consumer Measures.” Last modified November 2013. http://www.conference-board.org/data/consumerdata.cfm.
- Welcome to Economics!
- Choice in a World of Scarcity
- Demand and Supply
- Labor and Financial Markets
- The Macroeconomic Perspective
- Economic Growth
- The International Trade and Capital Flows
- Introduction to the International Trade and Capital Flows
- Measuring Trade Balances
- Trade Balances in Historical and International Context
- Trade Balances and Flows of Financial Capital
- The National Saving and Investment Identity
- The Pros and Cons of Trade Deficits and Surpluses
- The Difference between Level of Trade and the Trade Balance
- The Aggregate Demand/Aggregate Supply Model
- Introduction to the Aggregate Demand/Aggregate Supply Model
- Macroeconomic Perspectives on Demand and Supply
- Building a Model of Aggregate Demand and Aggregate Supply
- Shifts in Aggregate Supply
- Shifts in Aggregate Demand
- How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
- Keynes’ Law and Say’s Law in the AD/AS Model
- The Keynesian Perspective
- The Neoclassical Perspective
- Money and Banking
- Monetary Policy and Bank Regulation
- Exchange Rates and International Capital Flows
- Government Budgets and Fiscal Policy
- The Impacts of Government Borrowing
- Macroeconomic Policy Around the World
- International Trade
- Globalization and Protectionism
- Introduction to Globalization and Protectionism
- Protectionism: An Indirect Subsidy from Consumers to Producers
- International Trade and Its Effects on Jobs, Wages, and Working Conditions
- Arguments in Support of Restricting Imports
- How Trade Policy Is Enacted: Globally, Regionally, and Nationally
- The Tradeoffs of Trade Policy
- The Use of Mathematics in Principles of Economics
- The Expenditure-Output Model