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Aggregate Demand by RENEE HALTOM

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Aggregate Demand by RENEE HALTOM JARGONALERT Aggregate Demand BY RENEE HALTOM hat determines how much the economy pro- cycles but as a workable prescription for how policymakers duces in any given period? One way to think should respond to them. This backfired when attempts to Wabout it is through the concept of aggregate continually boost aggregate demand worked a little too well, demand, along with a partner concept, aggregate supply. resulting in inflation. The lesson was that the economy can’t An aggregate demand curve displays the quantity of goods be pushed beyond its sustainable level of supply for long. and services that are demanded at every possible price level in But many economists continue to argue that economists the economy. The aggregate quantity of goods and services should counteract demand shortfalls in recessions. This is demanded generally is high when prices are low and low when what the 2009 fiscal stimulus law tried to do. And in the prices are high (the opposite being true for aggregate supply, aftermath of the Great Recession, Christina Romer, then which slopes upward). Where the two intersect is, in theory, head of the President’s Council of Economic Advisers, at the current level of gross domestic product (GDP). noted the presence of factors that Keynes might have agreed This theoretical framework can help economists think would be harmful to aggregate demand: a fall in wealth fol- through the causes of business cycles. For example, four com- lowing the 2007-2008 financial crisis, disruptions of credit, ponents of aggregate demand cause the aggregate demand shrinking government spending, and cautious spending from curve to shift outward when they increase: the amounts nervous consumers. households want to consume, businesses want to invest, gov- The remedy, she said, would be “new actions aimed at ernments want to spend, or foreigners stimulating aggregate demand” such as want to purchase (minus the amount we federal assistance to state governments, purchase from them) at any given price tax incentives for hiring, funding for level. Each component is driven by dif- small businesses, and even consumer ferent factors; consumption, for example, incentives to make homes energy is affected by interest rates, disposable efficient. income, and expectations for the future. Critics argue that appeals to aggre- Aggregate demand is easily confused gate demand shortfalls often are sim- with GDP, the broadest and most com- ply an excuse for constituent-pleasing monly used measure of economic activity. spending that risks distorting the allo- GDP in the United States is measured cation of resources. Moreover, there are regularly by the Bureau of Economic Analysis as the sum of circumstances when aggregate demand should fall or grow final spending on consumption, investment, government less quickly, namely, when the economy’s productive poten- spending, and net exports. Thus, these four measures are both tial has done the same. It can be hard to identify such effects the accounting components of GDP and the causes of a shift in real time, which explains the heated debates during and in the theoretical concept of aggregate demand. after the Great Recession about whether unemployment When the BEA reports that GDP has declined, that’s was the result of structural or cyclical forces. what economist call a recession — which often ignites debates In the critics’ view, it is somewhat pointless to try and dis- about whether the government should attempt to boost entangle whether a recession stems from aggregate demand aggregate demand. This idea stems from the work of British or from aggregate supply. Instead, policy should focus on the economist John Maynard Keynes. In the throes of the Great factors that gum up the economy’s adjustment to shocks. Depression, he proposed that the government should coun- For example, recessions tend to make consumers nervous teract declines in aggregate demand by stepping in to spend about future job prospects, thus causing them to postpone itself. major purchases or vacations and increase savings, called Up to that point, the prevailing view of business cycles a spike in precautionary savings. The reaction may make held that recessions last about as long as it takes for the price perfect sense for each individual household while worsening system to reallocate goods and services, a process thought the recession in the aggregate. The fundamental problem — to be reasonably quick. This view focused on the economy’s the fact that it is hard for households to insure themselves long-run potential as the primary determinant of the level against the risk of unemployment — could be addressed of economic activity. Keynes, in contrast, argued that prices with enhanced unemployment benefits. can be quite sticky, forcing output to contract for sustained Such policies can appeal to both camps; Romer also periods in response to negative shocks to aggregated demand. suggested an expansion of unemployment benefits to help By the 1960s, the theory of aggregate demand shortfalls boost spending by those households — and thus aggregate became widely accepted as not just a description of business demand. EF ILLUSTRATION: TIMOTHY COOK 10 E CON F OCUS | F OURTH Q UARTER | 2014.
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