Learning Objectives

• Explain how imports influence AD
• Identify ways in which business confidence and consumer confidence can affect AD
• Explain how government policy can change AD
• Evaluate why economists disagree on the topic of tax cuts

How Changes by Consumers and Firms Can Affect Aggregate Demand

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 on their website at http://www.sca.isr.umich.edu (2015). 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. Since then, confidence has climbed from a 2011 low of 55.8 back to a level in the low 80s, which is considered close to being considered a healthy state.

One measure of business confidence is published by the Organisation for Economic Co-operation and Development (OECD): the business tendency surveys (Organisation for Economic Co-operation and Development, 2015). Business opinion survey data is collected for 21 countries on future selling prices and employment, among other elements of the business climate. After sharply declining during the Great Recession, the measure has risen above zero again and is back to long-term averages—the indicator dips below zero when 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 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 Figure 10.8 (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 Figure 10.8 (b).

Figure 10.8 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 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 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 10.8 (a), while lower government spending will cause AD to shift to the left, as in Figure 10.8 (b). For example, in the United States, government spending declined by 3.2 percent of GDP during the 1990s, from 21 percent of GDP in 1991, and to 17.8 percent of GDP in 1998. However, from 2005-2009, the peak of the Great Recession, government spending increased from 19 percent of GDP to 21.4 percent 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 percent of GDP is equal to close to $300 billion.

The tax policy an also affect consumption and investment spending. 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 AS and AD framework, however, offers a complementary rationale, as illustrated in Figure 10.9. 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 10.9 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.

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 AD 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 AD.

Spelling out the details of these alternative policies and how they affect the components of AD can wait for The Keynesian Perspective chapter. Here, the key lesson is that a shift of the AD curve to the right leads to a greater real GDP and to upward pressure on the price level. Conversely, a shift of AD 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.