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? What about a positive report? A negative report on home prices would make consumers feel like the value of their homes, which for most Americans is a major portion of their wealth, has declined.
A negative report on consumer confidence would make consumers feel pessimistic about the future. Both of these would likely reduce consumer spending, shifting AD to the left, reducing GDP and the price level.
A positive report on the home price index or consumer confidence would do the opposite. Name some factors that could cause AD to shift, and say whether they would shift AD to the right or to the left.
Would a shift of AD to the right tend to make the equilibrium quantity and price level higher or lower? What about a shift of AD to the left? If households decide to save a larger portion of their income, what effect would this have on the output, employment, and price level in the short run?
What about the long run? If firms become more optimistic about the future of the economy and, at the same time, innovation in 3-D printing makes most workers more productive, what is the combined effect on output, employment, and the price-level?
Student View. Preview Copy. Save Please log in to save materials. Show More Show Less. Course Alignments. Do imports diminish aggregate demand? When AD shifts to the right, the new equilibrium E 1 will have a higher quantity of output and also a higher price level compared with the original equilibrium E 0.
In this example, the new equilibrium E 1 is also closer to potential GDP. An increase in government spending or a cut in taxes that leads to a rise in consumer spending can also shift AD to the right. When AD shifts to the left, the new equilibrium E 1 will have a lower quantity of output and also a lower price level compared with the original equilibrium E 0.
In this example, the new equilibrium E 1 is also farther below potential GDP. A decrease in government spending or higher taxes that leads to a fall in consumer spending can also shift AD to the left.
In this example, the level of output Y 0 at the equilibrium E 0 is relatively far from the potential GDP line, so it can represent an economy in recession, well below the full employment level of GDP. In contrast, the level of output Y 1 at the equilibrium E 1 is relatively close to potential GDP, and so it would represent an economy with a lower unemployment rate. Do economists favor tax cuts or oppose them? Show Hint Hint: An increase in the value of the stock market would make individuals feel wealthier and thus more confident about their economic situation.
Show Hint Hint: Tax cuts increase consumer and investment spending, depending on where the tax cuts are targeted. During a recession , when unemployment is high and many businesses are suffering low profits or even losses, the U. Congress often passes tax cuts. During the recession of , for example, a tax cut was enacted into law. At such times, the political rhetoric often focuses on how people going through hard times need relief from taxes. The aggregate supply and aggregate demand framework, however, offers a complementary rationale, as illustrated in Figure 2.
The original equilibrium during a recession is at point E 0 , 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 E 1 , 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 Clear It Up feature to consider the question of whether economists favor tax cuts or oppose them. One of the most fundamental divisions in American politics over the last few decades has been between those who believe that the government should cut taxes substantially and those who disagree. Ronald Reagan rode into the presidency in partly because of his promise, soon carried out, to enact a substantial tax cut. No new taxes! Bush and Al Gore advocated substantial tax cuts and Bush succeeded in pushing a package of tax cuts through Congress early in Disputes over tax cuts often ignite at the state and local level as well.
What side are economists on? 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 the tax cuts are accompanied by equally large government spending cuts. Economists differ, as does any broad cross-section of the public, on how large government spending should be and what programs might be cut back.
A second issue, more relevant to the discussion in this chapter, concerns how close the economy is to the full employment level of output. In a recession, when the intersection of the AD and AS curves is 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 doing extremely well, tax cuts may shift AD so far to the right as to generate inflationary pressures, with little gain to GDP.
Similarly, the Bush tax cuts of and the Obama tax cuts of were enacted during recessions. However, some of the same economists who favor tax cuts in time of recession would be much more dubious about identical tax cuts at a time the economy is performing well and cyclical unemployment is low. The use of government spending and tax cuts can be a useful tool to affect aggregate demand and it will be discussed in greater detail in the Government Budgets and Fiscal Policy chapter and The Impacts of Government Borrowing.
If the interest rate increases, investment falls as the cost of investment rises. There are a number of ways that investment can fall. If the interest rate rises, say due to contractionary monetary or fiscal policy, investment will fall. Similarly, in the short run, expansionary fiscal policy will also cause investment to fall as crowding out occurs. Another interesting cause of a fall in investment is an exogenous decrease in investment spending.
This occurs when firms simply decide to invest less without regard for the interest rate. The term variable that will lead to a shift in the aggregate demand curve is G. This term captures the whole of government spending. The only way that government spending is changed is though fiscal policy. Recall that the budgetary debate is an ongoing political battlefield.
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.
For example, Hurricane Katrina caused negative supply and demand shocks in New Orleans and the surrounding areas. Aggregate demand is the total amount of goods and services in an economy that consumers are willing to pay for within a certain time period.
Aggregate demand is calculated as the sum of consumer spending, investment spending, government spending, and the difference between exports and imports. Whenever one of these factors changes and when aggregate supply remains constant, then there is a shift in aggregate demand. Utilizing the aggregate demand curve, a shift to the left, a reduction in aggregate demand, is perceived negatively, while a shift to the right, an increase in aggregate demand, is perceived positively.
Fiscal Policy.
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