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Key Takeaways Aggregate demand AD is the total amount of goods and services in an economy that consumers are willing to purchase during a specific time frame.
When aggregate demand changes in its relationship with aggregate supply, this is known as a shift in aggregate demand. Aggregate demand consists of the sum of consumer spending, investment spending, government spending, and the difference between exports and imports.
When any of these aggregate demand inputs change, then there is a shift in aggregate demand. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear.
Investopedia does not include all offers available in the marketplace. Related Articles. Partner Links. No new taxes! Bush and Al Gore advocated substantial tax cuts and Bush succeeded in pushing a tax cut package through Congress early in More recently in , Donald Trump has pushed for tax cuts to stimulate the economy.
Disputes over tax cuts often ignite at the state and local level as well. What side do economists take? 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 equally large government spending cuts accompany the tax cuts. Economists differ, as does any broad cross-section of the public, on how large government spending should be and what programs the government might cut back. A second issue, more relevant to the discussion in this chapter, concerns how close the economy is to the full employment output level.
In a recession, when the AD and AS curves intersect 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 performing extremely well, tax cuts may shift AD so far to the right as to generate inflationary pressures, with little gain to GDP.
Similarly, Congress enacted the Bush tax cuts and the Obama tax cuts during recessions. However, some of the same economists who favor tax cuts during recession would be much more dubious about identical tax cuts at a time the economy is performing well and cyclical unemployment is low. 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 discus 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 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.
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 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. 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. 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.
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. Tax cuts increase consumer and investment spending, depending on where the tax cuts are targeted. 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? 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. This is called a negative demand shock. The next module on the Keynesian Perspective will discuss the components of aggregate demand and the factors that affect them in more detail. 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.
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 or investment I.
When an American consumer or business buys a foreign product, it gets counted along with all other consumption and investment. 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 or investment 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 or I terms, and they always cancel out. 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 is used as a base year and set equal to , and confidence in every other year can be compared to that base year. Measured on this scale, for example, consumer confidence rose from in August to in February , but had plummeted to 56 by early As of October , the index had a value of 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 Surveys of Consumers, University of Michigan , which break 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 , which was the lowest it had been since Since then, confidence has climbed from a low of After sharply declining during the Great Recession, the measure has risen above again and is back to long-term averages.
Of course, none of these survey measures are 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 E 0 to E 1 , to a higher quantity of output and a higher price level, as you can see in the following interactive graph Figure 1 :.
Figure 1 Interactive Graph. Shifts in Aggregate Demand. 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.
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 E 0 to E 1 , to a lower quantity of output and a lower price level, can be seen in the following interactive graph Figure 2 :.
Figure 2 Interactive Graph. Government spending is one component of AD.
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