Consumer Spending Habits: Changes in Aggregate Demand

Changes in Aggregate Demand The amount of final products demanded does not depend on the price level alone. Aggregate demand is also influenced by such economic variables as wealth, interest rates, foreign exchange rates, and expectations about the future. A change in aggregate demand is a change in the amount of a nation's final products that will be purchased caused by something other than a change in the price level. A change in aggregate demand is represented by an inward or outward shift of the economy's aggregate demand curve. The distinction between a change in aggregate demand and a change in aggregate quantity demanded is similar to the distinction between change in demand and change in quantity demanded for market demand curves. A change in aggregate quantity demanded is a movement along a given aggregate demand curve that occurs in response to a change in the price level. A change in aggregate demand, however, implies a movement of the entire aggregate demand curve. When aggregate demand increases or decreases, the relationship between the price level and aggregate quantity demanded is altered. The graphs in Boxes 2 and 3 illustrate changes in aggregate demand. An increase in aggregate demand implies an outward shift of the aggregate demand curve while a decrease in aggregate demand implies an inward shift of the curve. Influences on Aggregate Demand Changes in the economy cause changes in aggregate demand by affecting the willingness of consumers to spend their income on the final products of domestic producers. Business demand for investment goods fluctuates as can government purchases. Similarly changes in the demand for our exports can influence aggregate demand for the products of domestic producers. Much of the macroeconomic analysis to follow in the next few chapters will examine in depth the various influences on aggregate demand. At this point we will briefly list them: 1. Real interest rates. When real interest rates go up, businesses cut back on their plans to buy new equipment and structures, and households find they cannot afford the monthly payments necessary to buy such items as furniture, cars, and new homes. An increase in real interest rates, therefore, causes a decrease in aggregate demand while a decrease in real interest rates results in an increase in aggregate demand. 2. The quantity of money in circulation. Suppose the government were to suddenly declare that each dollar people held in their pockets as currency or on deposit in banks was now worth two dollars. As a result, aggregate demand would increase because people would have more money to spend. As you will soon see, unrestrained increases in the quantity of money in circulation by central banking authorities is a major cause of inflation and hyperinflation. On the other hand, a decrease in the quantity of money would decrease aggregate demand. 3. Changes in the international value of the dollar. As the price of the dollar goes up in terms of foreign currencies, our exports become more expensive in foreign markets while imports become cheaper (other things being equal) to U.S. buyers. A higher dollar decreases aggregate demand by decreasing the demand for our exports and stimulating domestic demand for imports. As the price of the dollar goes down, prices of our exports also fall in terms of foreign currencies stimulating demand for them while the price of imports goes up in dollars thereby encouraging U.S. consumers to substitute domestic products for imports. A decrease in the price of the dollar, therefore, results in an increase in aggregate demand. Changes in foreign exchange rates can have a major impact on an economy like the United States where increasingly large proportions of spending are accounted for by imports and exports. 4. Wealth. Wealth consists of assets like stocks, bonds, and real estate that can be sold, if necessary, to provide money for spending. When stock prices are high, consumers who hold stocks are likely to be more willing to spend their current income rather than save it. Conversely, when the value of stocks and other assets (such as land and homes) fall, aggregate demand can decrease. For example, when stock prices fell in 1929, aggregate demand plummeted as the savings of millions of stockholders were wiped out. However, the link between short-term changes in wealth and aggregate demand is not always clear cut. In 1987 when there was another major stock market crash, many economists predicted a sharp cutback in aggregate demand. The effects, however, proved to be negligible and aggregate demand continued to increase in 1987 and 1988. 5. Government purchases, taxes, and transfers. An increase in government purchases of goods and services increases aggregate demand while a decrease in such purchases decreases aggregate demand. Taxes take a portion of income earned by households and businesses out of the spending stream. An increase in tax rates, other things being equal, decreases disposable income to households and is likely to decrease aggregate demand. Conversely, a decrease in tax rates is likely to increase aggregate demand because disposable income will increase. Transfer payments are a source of income to millions of Americans on social security pensions and to those who depend on welfare or unemployment benefits. Transfers influence consumption expenditures and when they increase, aggregate demand also increases. For example, when the unemployment rate goes up, aggregate demand tends to decrease because labor earnings decline. However, unemployment insurance compensation (which is a transfer) goes up when the unemployment rate increases. The increase in transfer payments from unemployment insurance acts to increase aggregate demand thereby cushioning the impact of increased cyclical unemployment on the economy. 6. Expectations about the future. If the outlook for future increases in disposable income is bleak, consumers are likely to cut back on spending. The decrease in aggregate demand resulting from a decline in the demand for consumption goods can feed back on business firms and reduce the demand for investment goods. If businesses do not think they can sell all their current production, they are unlikely to be willing to purchase more inventory. machines, equipment, or to plan new plants. When expectations turn up, aggregate demand is also likely to increase. 7. Income and other economic conditions affecting demand in foreign countries. When income is increasing in foreign nations, their demand for such U.S. products as aircraft, beef, and lumber also goes up. This would increase aggregate demand in the United States. Conversely, if income in the rest of the world declines, there will be a decrease in the demand for U.S. exports, and the aggregate demand curve would shift inward. Box 4 summarizes the major factors that can result in a change in aggregate demand.