119 Shifts in 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 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. As of October 2017, the index had a value of 125.9.

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 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 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 of 98.5 in October 2017 which is considered healthy.

The OECD, an group consisting of the major developed countries, publishes the Business Confidence Index. After sharply declining during the Great Recession, the measure has risen above 100 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 E₀ to E₁, to a higher quantity of output and a higher price level, as you can see in the following interactive activity (Figure 1):

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, can be seen in the following interactive activity (Figure 2):

Government spending is one component of AD. Thus, higher government spending will cause AD to shift to the right, as in Figure 1, while lower government spending will cause AD to shift to the left, as in Figure 2. 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. Figure 3 illustrates the effect of tax cuts using the AD-AS model. 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 feature to consider the question of whether economists favor tax cuts or oppose them.

Government Policy Options

Changes in government spending and tax rates can be useful for influencing aggregate demand. Other policy tools can shift the aggregate demand curve as well. For example, 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 until we learn about the Keynesian Perspective in greater detail. 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.