ECON102: Principles of Macroeconomics

As we 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 an 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 consumer or firm behavior and changes in government tax or spending policy.

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 University of Michigan publishes a survey of consumer confidence and constructs an index of consumer confidence each month. The survey results are then reported at http://www.sca.isr.umich.edu, which breaks down the change in consumer confidence among different income levels. According to that index, consumer confidence averaged around 90 prior to the Great Recession, and then it fell to below 60 in late 2008, which was the lowest it had been since 1980. During the 2010s, confidence climbed from a 2011 low of 55.8 back to a level in the upper 90s before falling to the lower 70s in 2020 due to the COVID-19 pandemic, which economists consider close to a healthy state.

The Organization for Economic Development and Cooperation (OECD) publishes one measure of business confidence: the "business tendency surveys." The OECD collects business opinion survey data for 21 countries on future selling prices and employment, among other business climate elements. After sharply declining during the Great Recession, the measure has risen above zero again. It is back to long-term averages (the indicator dips below zero when the business outlook is weaker than usual). Of course, either of these survey measures is not very precise. They can, however, suggest when confidence is rising or falling, as well as when it is relatively high or low compared to the past.

Because economists associate a rise in confidence 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 Figure 11.8(a) shows.

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. Figure 11.8 (b) shows 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.

Figure 11.8 Shifts in Aggregate Demand (a) An increase in consumer confidence or business confidence can shift AD to the right, from AD₀ to AD₁. When AD shifts to the right, the new equilibrium (E₁) will have a higher quantity of output and also a higher price level compared with the original equilibrium (E₀). In this example, the new equilibrium (E₁) is also closer to the potential GDP. An increase in government spending or a cut in taxes that leads to a rise in consumer spending can also shift AD to the right. (b) A decrease in consumer confidence or business confidence can shift AD to the left, from AD₀ to AD₁. When AD shifts to the left, the new equilibrium (E₁) will have a lower quantity of output and also a lower price level compared with the original equilibrium (E₀). In this example, the new equilibrium (E₁) is also farther below the potential GDP. A decrease in government spending or higher taxes that leads to a fall in consumer spending can also shift AD to the left.

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 Figure 11.8 (a), while lower government spending will cause AD to shift to the left, as in Figure 11.8 (b). For example, in the United States, government spending declined by 3.2% of GDP during the 1990s, from 21% of GDP in 1991 to 17.8% of GDP in 1998. However, from 2005 to 2009, the peak of the Great Recession, government spending increased from 19% of GDP to 21.4% of GDP. If changes of a few percentage points of GDP seem small to you, remember that since GDP was about $14.4 trillion in 2009, a seemingly small change of 2% of GDP is equal to close to $300 billion. Since 2009, government expenditures have gone back down to around 17–18% of GDP, although in 2020 they rose to 18.5%.

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 2001 recession, for example, the U.S. Congress enacted a tax cut into law. At such times, the political rhetoric often focuses on how people experiencing hard times need relief from taxes. The aggregate supply and aggregate demand framework, however, offers a complementary rationale, as Figure 11.9 illustrates. 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.

Figure 11.9 Recession and Full Employment in the AD/AS Model Whether the economy is in a recession is illustrated in the AD/AS model by how close the equilibrium is to the potential GDP line as indicated by the vertical LRAS line. In this example, the level of output Y₀ at the equilibrium E₀ is relatively far from the potential GDP line, so it can represent an economy in recession, well below the full employment level of GDP. In contrast, the level of output Y₁ at the equilibrium E₁ is relatively close to potential GDP, and so it would represent an economy with a lower unemployment rate.

Government spending and tax rate changes can be useful tools to affect aggregate demand. Other policy tools can shift the aggregate demand curve as well. For example, as we will discuss in the Monetary Policy and Bank Regulation chapter, the Federal Reserve can affect interest rates and credit availability. 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 businesses. 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.

Clarifying 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 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 AS curve's relatively flat or relatively steep portion.

Source: Rice University, https://openstax.org/books/principles-macroeconomics-3e/pages/11-4-shifts-in-aggregate-demand
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