The aggregate demand curve tends to shift to the left when total consumer spending declines. Consumers might spend less because the cost of living is rising or because government taxes have increased. Consumers may decide to spend less and save more if they expect prices to rise in the future. It might be that consumer time preferences change and future consumption is valued more highly than present consumption.
Contractionary fiscal policy can also shift aggregate demand to the left. The government might decide to raise taxes or decrease spending to fix a budget deficit. Monetary policy has less immediate effects. If monetary policy raises the interest rate, individuals and businesses tend to borrow less and save more.
This could shift AD to the left. The last major variable, net exports exports minus imports , is less direct and more controversial. This would imply a net influx of foreign currency or dollars held abroad to pay for the fact that foreigners are buying more U. This situation would lead to an increase in U.
According to macroeconomic theory, a demand shock is an important change somewhere in the economy that affects many spending decisions and causes a sudden and unexpected shift in the aggregate demand curve. Some shocks are caused by changes in technology. Technological advances can make labor more productive and increase business returns on capital.
This is normally caused by declining costs in one or more sectors, leaving more room for consumers to buy additional goods, save, or invest. In this case, the demand for total goods and services increases at the same time prices are falling. Diseases and natural disasters can cause demand shocks if they limit earnings and cause consumers to buy fewer goods.
Another factor that can change consumption and shift aggregate demand is tax policy. A cut in personal income taxes leaves people with more after-tax income, which may induce them to increase their consumption.
The federal government in the United States cut taxes in , , , , and ; each of those tax cuts tended to increase consumption and aggregate demand at each price level. In the United States, another government policy aimed at increasing consumption and thus aggregate demand has been the use of rebates in which taxpayers are simply sent checks in hopes that those checks will be used for consumption.
Rebates have been used in , , and In each case the rebate was a one-time payment. Careful studies by economists of the and rebates showed little impact on consumption. Final evidence on the impact of the rebates is not yet in, but early results suggest a similar outcome.
In a subsequent chapter, we will investigate arguments about whether temporary increases in income produced by rebates are likely to have a significant impact on consumption. Transfer payments such as welfare and Social Security also affect the income people have available to spend. At any given price level, an increase in transfer payments raises consumption and aggregate demand, and a reduction lowers consumption and aggregate demand.
Investment is the production of new capital that will be used for future production of goods and services. Firms make investment choices based on what they think they will be producing in the future. The expectations of firms thus play a critical role in determining investment. If firms expect their sales to go up, they are likely to increase their investment so that they can increase production and meet consumer demand.
Such an increase in investment raises the aggregate quantity of goods and services demanded at each price level; it increases aggregate demand. Changes in interest rates also affect investment and thus affect aggregate demand. We must be careful to distinguish such changes from the interest rate effect, which causes a movement along the aggregate demand curve.
A change in interest rates that results from a change in the price level affects investment in a way that is already captured in the downward slope of the aggregate demand curve; it causes a movement along the curve. A change in interest rates for some other reason shifts the curve.
We examine reasons interest rates might change in another chapter. Investment can also be affected by tax policy. One provision of the Job and Growth Tax Relief Reconciliation Act of was a reduction in the tax rate on certain capital gains. Capital gains result when the owner of an asset, such as a house or a factory, sells the asset for more than its purchase price less any depreciation claimed in earlier years.
The lower capital gains tax could stimulate investment, because the owners of such assets know that they will lose less to taxes when they sell those assets, thus making assets subject to the tax more attractive. Any change in government purchases, all other things unchanged, will affect aggregate demand. An increase in government purchases increases aggregate demand; a decrease in government purchases decreases aggregate demand. Many economists argued that reductions in defense spending in the wake of the collapse of the Soviet Union in tended to reduce aggregate demand.
Similarly, increased defense spending for the wars in Afghanistan and Iraq increased aggregate demand. Dramatic increases in defense spending to fight World War II accounted in large part for the rapid recovery from the Great Depression.
A change in the value of net exports at each price level shifts the aggregate demand curve. For example, several major U. Lower real incomes in those countries reduced U. Exchange rates also influence net exports, all other things unchanged. A rise in the U. That also means that U.
Since prices of goods produced in Japan are given in yen and prices of goods produced in the United States are given in dollars, a rise in the U. For example, the construction of a dam provides benefits to farmers, homeowners who are protected from floods, fishermen who can use the reservoirs, and so on.
This makes charging precise fees based on the use of infrastructure difficult, and it argues that the public benefits of infrastructure should simply be paid for with public funds. Finally, some infrastructure investment provides services that society has decided should be available to all as basic rights safe drinking water, for example even if some customers are not profitable to serve for a strictly private entity. The federal role is strongest in new capital spending, as opposed to operation and maintenance.
Nearly 40 percent of all state and local capital spending on transportation and water infrastructure is financed by grants from the federal government. In short, governments at all levels, but particularly the federal government, are big players every year in infrastructure investment.
Overall spending on infrastructure as a share of gross domestic product GDP has been in long-term decline. The first lower line shows public investment in water and transportation. The second higher line includes public investments in the construction of educational and hospital structures as well as investments in conservation, development, utilities, ports, and airfields. Think of these as narrow and broad measures of infrastructure. Each saw sharp reductions in the s, and the rebound since then has still left them far below the levels that prevailed on average before Notes: The broad infrastructure series includes public investment in hospital and educational structures, highways, sewers, transportation facilities, and conservation and development.
Moreover, there is strong evidence that because the prices of infrastructure investments are rising more rapidly than overall prices, a greater share of nominal spending must be undertaken just to keep the quality of infrastructure intact.
Figure B shows two measures of transportation and water infrastructure, taken from a recent report by the Congressional Budget Office CBO.
One deflates the transportation spending by the overall deflator for gross domestic product, while the other deflates it by an infrastructure-specific deflator. The latter measure—which more accurately reflects the services provided by a given nominal amount of infrastructure spending—grows much more slowly in recent periods.
Note: Infrastructure-specific deflator uses prices of materials and other inputs used to build, operate, and maintain transportation and water infrastructure. Given the large role the federal government plays in providing resources for infrastructure investment, and given that this investment effort has fallen in recent decades, recent calls to boost the rate of infrastructure investment would seem to have prima facie merit.
The rest of this paper highlights the near-term and long-term potential benefits from an increased federal infrastructure investment effort. Since the Great Recession began, increased infrastructure investment has been suggested as a primary tool to restore the economy to full health. Infrastructure was not part of the first stimulus package meant to fight the Great Recession, the Economic Stimulus Act of , despite some calls for it to be included Mishel, Eisenbrey, and Irons Given that unemployment in was still significantly higher 4.
Infrastructure projects started in , , or even in could have helped the economic recovery. Even as of March , many measures of economic slack indicate that the economy could benefit from a boost in aggregate demand.
The share of prime-age age 25—54 adults who were employed, for example, was 1. This may not sound like a lot, but this translates into roughly 1. Despite unemployment in March essentially matching its average, nominal wage growth for production and supervisory workers for the year ending in March was 2.
In this wage growth was 4. This sluggish wage growth has in turn made it hard for the Federal Reserve to maintain price inflation at their 2 percent target. So far, the lessons of these analyses have not been heeded. For example, fiscal policy has not been more expansionary during the recovery from the Great Recession relative to past recoveries. A renewed push to increase infrastructure investment could move fiscal policy from being a drag on growth to being a boost to growth in coming years.
Perhaps relevant to upcoming fiscal policy debates, infrastructure investment is routinely estimated to be a much more efficient fiscal stimulus than almost any form of tax cut, and it is significantly more efficient than those tax cuts whose benefits fall mostly on high-income households.
Table 1 provides a range of comparisons of various types of fiscal policy interventions. Many of these are taken from the research literature that existed before ARRA. Since then, most research on fiscal stimulus undertaken when monetary policy is accommodating has found even higher multipliers most famously, perhaps, in Blanchard and Leigh But the relative ranking of various fiscal policy interventions has largely been confirmed.
To give a quick sense of the employment consequences of infrastructure investment in the near-term, note that an output multiplier of 1. This increase in GDP would in turn boost employment by a bit over 1 million workers see Bivens for the relationships between output and employment. The primary virtue of infrastructure investment as fiscal stimulus is that it is spent.
Tax cuts and even direct transfer payments can be saved by households. Because transfer payments tend to be directed toward low-income and hence cash-constrained households, they tend to not be saved and hence rival infrastructure investment as stimulus. But infrastructure investment is guaranteed, always and everywhere, to be spent. Since , research on the causal effect of infrastructure spending on short-run output and employment has been bolstered by the examination of large, exogenous fiscal events: the large fiscal boost provided by ARRA in the United States, the large but quite variable fiscal contraction undertaken by countries in the European Union EU , and anti-corruption efforts in Italy.
Acconcia, Corsetti, and Simonelli examine the fiscal shock that occurs in Italian provinces when public construction projects are halted in response to findings of Mafia involvement. A law issued to combat public corruption provides for forceful and sudden halts to construction activity when local police find evidence of Mafia involvement. This provides an exogenous shock to fiscal spending that can be linked to subsequent changes in economic output. Such exogeneity is needed in studies of fiscal stimulus because of the ever-present possibility of two-way causality: fiscal changes can affect economic growth, but economic growth can also in theory affect fiscal changes.
Using this high-quality instrument that isolates exogenous fiscal changes i. Blanchard and Leigh examine the large but varied fiscal adjustments undertaken by EU members in response to the Euro crisis of — They regress the fiscal adjustments against the predicted pace of output growth in the next two years and They find a systematic and negative relationship between the fiscal adjustments and the forecast error of subsequent output growth, suggesting that fiscal multipliers are substantially larger than forecasters assumed a priori.
They interpret their results as indicating an overall fiscal multiplier of 1. They also find that spending adjustments matter more than revenue adjustments in restraining output growth. They find that reductions in government investment have significantly larger negative effects on subsequent output growth than reductions in consumption spending. If this highway spending created jobs across economic sectors in exact proportion to existing employment shares, this would be consistent with an output multiplier of 1.
Figure C shows the trajectory of employment from December to June in the highest fifth of states, ranked by ARRA highway funds, versus the lowest fifth of states. As consumers in a country increase spending, it directly increases aggregate demand.
Tax cuts could decrease individual income taxes, sales taxes or property taxes. Increases in foreign-based purchases and direct investments can lead to an increase in aggregate demand.
Variations in exchange rates can cause the price of foreign-made goods to be cheaper than domestic products. If consumers in another country demand more goods from abroad, their purchases increase aggregate demand in the country where the goods are obtained.
The purchases also increase the available cash in the supplying country, which leads to greater consumer spending and an additional increase in aggregate demand. Money also can come in the form of direct investments into companies or raw materials.
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