"  The Wealth Effect  
Will your money buy as much if prices soar? Of course not. A higher price level reduces the purchasing power of financial wealth. Assets such as stocks, bonds, cash, and checking account balances are worth less, which shrinks the amounts you can buy.8 Thus, higher average prices reduce the amount of domestic production sold along an Aggregate Demand curve.

"  The Foreign-Sector Substitution Effect  
Might buyers tend to switch from Buicks to Saabs if prices of American cars rose relative to those for imports? Of course. Higher U.S. prices cause domestic consumers to buy more imports and fewer American goods. Foreign buyers respond similarly, shrinking U.S. exports.

Investment is affected in a similar fashion. Hikes in the price level drive up domestic production costs. If you headed a firm considering a new manufacturing facility, you would be more likely to build it in Mexico if U.S. prices and costs rose. Thus, a higher price level shrinks investment in this country because both foreign and U.S. firms would find it relatively more profitable to invest abroad. In sum, trends toward imports and foreign investments reinforce the wealth effect in making Aggregate Demand curves negatively sloped.9

"  The Interest Rate Effect  
The amount of borrowing required to finance a major purchase rises if the price level rises. For example, you might need to borrow more to finance your education if tuition costs were to rise. Thus, a higher price level increases the demand for loanable funds and, consequently, increases the interest rate, which is the cost of credit. This increase in interest rates reduces investment and such consumer purchases as new homes, cars, or appliances. Figure 5 summarizes how these effects cause movements along Aggregate Demand curves as the price level changes.

 

 

Shifts of Aggregate Demand Curves

Now that you have seen why the Aggregate Demand curve slopes downward, we need to explore why these curves shift. National income (output) is a major determinant of market demands for specific goods, but, in conjunction with the price level, it only identifies a specific point on an Aggregate Demand curve.10 Thus, the horizontal axis measures both national income and output. Changes in national income and the price level reflect movements along the Aggregate Demand curve; they do not cause it to shift. Aggregate Demand curves shift when planned spending changes for consumption (C), investment (I), government (G), or net exports to foreigners (X  M, or exports minus imports).

Consumer Spending (C)

Customary living standards and buying habits help shape consumption spending, which represents about two-thirds of Aggregate Demand. Planned consumption is also influenced by (a) disposable income, (b) wealth, (c) average size and ages of households, (d) stocks of consumer goods on hand and household balance sheets, and (e) consumer expectations about future prices, incomes, and availability of goods.

"  Disposable Income  
People are often upset by how sharply withholding taxes shrink their take-home pay below their stated salaries. Your disposable income is the amount available to spend after subtracting federal and state taxes and then adding any transfer payments (such incomes received, but not earned, as unemployment compensation or Social Security). On balance, these adjustments shrink aggregate disposable income to less than national income.

 

Keynesian theory (detailed in the next part of this book) emphasizes disposable income as the driving force behind consumer spending. Increases in disposable income stimulate saving somewhat, but most of it will be spent. Thus, changing relationships between national income and disposable income (e.g., new taxes or transfer payments) alter consumers spending plans and shift Aggregate Demand.

"  Wealth or Expected Income  
Is a new car purchase more likely for a senior accounting major at your college, or one majoring in philosophy? Expected higher income after graduation makes the accountant the more probable buyer. Now consider relative spending by a retired tycoon and a retired postal employee. Even a tycoon suffering huge stock market losses this year is likely to spend significantly more. The point is that wealthy people or those who expect higher incomes typically spend more than poorer people with identical current incomes. Similarly, people who fear losing their jobs tend to decrease their consumption. When expectations change, the Aggregate Demand curve shifts.

"  Household Size and Ages  
Big families spend proportionally more from income than small families. Young families busily acquire durables (e.g., cars and appliances), while established families tend to replace only worn-out durables. Thus, societies full of young or large families consume proportionally more from a given current income than societies composed of older or smaller families. Thus, as an economy s demographics shift, so does Aggregate Demand.

"  Household Balance Sheets  
A household s assets include such things as its productive resources, durable goods, and financial wealth; its debts are liabilities. Most families that are deeply in debt try to postpone spending to reduce their indebtedness. Financially secure families typically spend proportionally more from current income. Thus, shrinking debt stimulates consumption. Families may also spend more if more money becomes available.11

"  Consumer Expectations  
Consumer debt usually climbs when buyers stockpile goods to guard against inflation, but shaky confidence may reduce use of credit. If soaring prices for housing convince many young couples that they will never afford homes if they wait, panic buying pushes up housing prices even faster. When people expect widespread shortages, they hoard almost anything that can be stored. Outputs for consumers were limited during World War II, and shortages were rampant. Most consumers had long wish lists and went on spending binges at the war s end. Opposite trends occur if people have recently been on buying sprees: large household stocks of new durable goods diminish the need to purchase more.

Investment (I)

Economic investment enhances future consumption. (Remember that financial investments are merely specialized forms of saving.) Circular flow models identify firms as channels that convert household saving into investment, which falls into three basic categories: (a) new buildings and all other construction, (b) new equipment, and (c) inventory accumulation.

All investment is cyclically sensitive, but inventories are especially volatile. Erratic customer purchases allow firms only partial control over their inventories. Firms unintentionally invest in new inventories if sales are unexpectedly low, but inventories dwindle and unintentional disinvestment occurs if sales exceed forecasts. Unexpected inventory changes signal firms to adjust their hiring of resources and their orders to suppliers.

"  Expected Rates of Return  Planned investment spending depends powerfully on expected rates of return. Firms invest only if the new capital s revenue stream is expected to exceed all costs.

A rate of return is the annual percentage earned from an investment after all costs are considered.12

Rates of return, the level of investment, and Aggregate Demand are positively related to the net revenues expected from investment across time. Investors (and most other people) prefer more income to less and lower costs to higher costs. And, because time is valuable, they prefer current income to delayed income and try to postpone costs wherever possible. (Would you prefer an extra $1,000 now or a year from now? Would you rather pay $1,000 to the Internal Revenue Service now or ten years from now?) Another major influence on rates of return and investment is risk, which, all else being equal, investors try to avoid. Therefore, rates of return rise when expected revenues are greater, are expected sooner, or appear more certain, or when expected costs (including taxes) fall, are postponed, or involve less risk.

 

Investment is stimulated when technological advances are innovated. Innovations yielding high rates of return tend to arrive erratically and in waves. Consequently, investments to implement technological advances tend to be clustered over time.

"  Costs of Investment  
Expected returns rise when capital prices fall and shrink when construction or machinery costs rise. Upswings stimulate demands for such capital as lathes or computers, boosting capital prices and inhibiting surges in investment. Conversely, investor pessimism during downturns reduces orders for new capital goods. Capital suppliers then cut prices for new equipment to liquidate their excess inventories, slightly dampening drops in investment.

Interest, however, is the major cost of investment. Investors opportunity costs rise when interest rates rise; investors with ample funds might make loans instead of buying investment goods, and higher interest rates make investment less attractive for potential investors who must borrow. Taxes on investment income are another consideration. For example, higher corporate taxes shrink after-tax rates of return. Investment tax credits, on the other hand, boost rates of return and, consequently, demands for investment goods. Higher expected rates of return bolster both investment and Aggregate Demand, but investor pessimism shrinks both investment and Aggregate Demand (shifts it leftward).

Government (G)

Expectations about government policies also affect investment. For example, firms that rely on exports or imports might cancel new capital orders if restrictions on foreign trade were expected. Defense contractors invest heavily when war clouds loom and cut back investment with the advent of peace. But government affects Aggregate Demand most directly through its spending and its tax policies.

"  Government Purchases  
Government purchases such as highways or education resemble private investment by generating benefits over time. Other purchases immediately exhaust resources and resemble private consumption (e.g., police protection and Medicare). Both consumption and investment types of government purchases directly increase Aggregate Demand. Some government outlays, however, do not entail direct spending. For example, cash transfer payments are only translated into Aggregate Demand when the recipients spend these funds on consumer goods. Thus, these government outlays are not lumped into government purchases.

 

The percentage of output absorbed by government purchases rose substantially but erratically over this nation s first two centuries, growing most rapidly during wars. The Civil War, World Wars I and II, the Korean conflict, and the Vietnam War were peaks for government demands. Government purchases tend to shrink when a war ends, but rarely to earlier levels. One possible reason for upward trends in government spending is that rising standards of living may make voters willing to devote ever larger shares of income to such publicly provided goods as education or parks.

"  Tax Rates  
Consumption depends on disposable income, investment depends on after-tax rates of return, and how much (and what) we import depends on tariffs and import quotas, while how competitively we can produce goods for export depends, in part, on the burdens of taxation. Thus, higher tax rates generally decrease Aggregate Demand.

"  Money  Supply
When people have more money, they tend to spend it. A larger money supply, all else being equal, allows a greater supply of loanable funds, so interest rates will be lower. Lower interest rates stimulate borrowing and spending by both consumers and investors. The central bank of the United States is the Federal Reserve System. How this arm of government regulates the supply of money is detailed later in this book.

The Foreign Sector (X-M)

Exports (X) reflect foreign demands for U.S. goods. Thus, they increase Aggregate Demand. Imports (M) are goods produced by foreigners but used by American consumers, investors, or government. In fact, the accounting categories of consumption, investment, and government spending include many goods produced abroad. These imports augment Aggregate Supply but may reduce Aggregate Demand for domestic production because imports sometimes replace purchases of domestic output. This is one reason declining industries vigorously lobby for protection from foreign competition. For example, the auto, clothing, and steel industries have advocated tariffs and quotas for decades; computer makers have recently voiced similar pleas.

 

It is conventional to look only at net effects of the foreign sector on Aggregate Demand. National income undoubtedly influences U.S. imports. Domestic prosperity inspires imports of Mercedes-Benz cars, French champagne, and Nikon cameras, and our vacations and booming industrial output require more foreign oil. But U.S. exports depend primarily on economic conditions abroad, which may be in the doldrums even if the U.S. economy is prosperous.

 

Economic interdependence is, however, accurately characterized by the saying  When America sneezes, the rest of the world catches a cold. Although foreign trade is vital for economic vitality, the foreign sector s net effect on Aggregate Demand in the United States is relatively small. Exports and imports each average around 10% of our national income, so net exports (X  M) are usually only a negligible percentage of Aggregate Spending.

 

Review how all these influences shift the Aggregate Demand curves in Figure 6 before reading our overview of Aggregate Supply.