Here is where we need to think deeper about causality – the typically important things that cause changes in spending. Without a lot of fanfare, we list some of these key causal factors that forecasters and analysts examine because they are believed to impact the spending of households, firms, governments, and foreigners. This is not a complete list but it does contain some of the important causal factors for AD:
- Employment and hours worked
- Taxes and tax rates
- Value of stocks and bonds
- Value of real estate
- Interest rates
- Consumer confidence
- Business confidence
- Energy prices
- Political changes that might affect spending on defense, income security, etc
- Exchange rates
- Economic growth in foreign countries
If a forecaster believes that positive momentum in the economy will lead to more jobs in the coming year, then his/her process of AD thinking might be as follows – jobs create more income and more income causes households to spend more. This alone might cause AD to increase faster this year – and this increase in AD could lead to faster growth in real GDP and/or prices. In contrast, higher taxes and tax rates reduce a household’s disposable income, inducing the household to both spend and save less.
Similarly, when valuations on assets (like stocks, bonds, and real estate) rise, households may feel “richer” and want to spend more.
Another forecaster might worry that energy prices are going to continue rising in the coming time period. His/her AD reasoning might be something like – as people spend more on energy (a notably price inelastic good in the short-run) the typical household and firm will have less to spend on food, cars, and new machines. This would imply a slowdown in AD – and that could have the result of more slowly growing real GDP and/or prices.
The above discussion illustrates the key channels of how we get from AD-side demand change factors to things like GDP growth and inflation:
Here is a graph showing an increase in AD – notice how it leads to higher real GDP and prices. When AD increases (assuming the AS curve does not shift), we move from the intersection shown by the circle to the intersection shown by the square. The arrows indicate that this movement from the circle to the square brings higher prices and output. Thus, an increase in AD can lead to an expanding national economy with higher inflation.
This gets us back to our discussion about Potential Real GDP and the GDP gap. What happens when real GDP is not equal to its Potential in a particular year? That means policy makers may get into the action to try to fix things. That means that planners have even more to take into consideration if they want to predict or understand future changes in AD, GDP and inflation.
100 years ago economists didn’t think much about AD policy. It is a long story but they pretty much believed that unusual AD changes would be temporary and self-correcting. After the Great Depression of the 1930s many economists began to re-think AD. One economist, John Maynard Keynes, was quite effective in promoting the idea that AD changes were not self-correcting and that, especially when AD got very low, it might need some help from the government. People who call themselves Keynesians today generally believe that when AD is too low, the government ought to do something to resuscitate it. Of course, AD can also grow too fast. China has been an interesting example of a country wherein experts believed that AD could grow too fast. In that country policy makers have often engaged policies designed to slow AD.
But why do you care about all this? You aren’t a historian, right? Business people become “Fed-Watchers” or government policy-watchers because they realize that when the central bank or the government decides to impact AD – then these policy actions may well impact AD, real GDP growth, and inflation. So business plans are often as much impacted by the government’s AD stabilization attempts as they are by changes in oil prices or business confidence. In fact, all these things are quite intertwined.
Generally we think of AD policy in the following terms:
If AD appears too weak (as evidence by a negative GDP gap) then AD can be increased by any of the following policies:
- The central bank increases the money supply and reduces interest rates
- The government reduces income tax rates or other taxes
- The government spends more on goods
- The government increases entitlement programs
If AD appears too strong (as evidence by a positive GDP gap) then AD can be decreased by policy by:
- The central bank reduces the money supply and raises interest rates
- The government increases income tax rates or other taxes
- The government spends less on goods
- The government decreases entitlement programs
While the policy idea is pretty simple, the real world is a very challenging place for business planners and macro forecasters.
For example, right after the U.S. Fed began reducing interest rates in 2001 after the onset of the 2001 recession, there were at least three kinds of uncertainties in the minds of most of us:
How low will the Fed go? How low will they push interest rates?
How long will it take the lower interest rates to impact AD?
How much will AD be impacted? Will AD come roaring back?
You can see why most of us were very interested in these policy questions. There were a similar set of questions with respect to what George Bush and Congress would do. And what the Canadian, European, and Japanese governments would do.
While macroeconomics and AD can help us think about these things in an orderly way – we cannot predict the future. We try but there is no model so perfect and so stable and so comprehensive that it will always predict such things with accuracy. So that means most of us are left with the challenging task of predicting the changes in both causal variables and policy makers responses to them.
Difference of Opinion
The world is complicated and dynamic enough that we generally have differing opinions about almost everything. Doctors debate the best approach to cancer or the common cold. Sociologists argue about the roots of poverty. Astronomers debate about black holes. Macroeconomists have very differing views about AD policy. Conservative macroeconomists generally believe in a world that is often self-correcting and one in which activist policymakers often add too much uncertainty to short-run economic outcomes. Liberal economists don’t think the economic problems will disappear on their own – at least not quickly enough – and they are more likely to advocate more government intervention into the economy.
The importance of these kinds of opinion differences is that we know that most governments at most times are impacted by a wide range of opinions about what they “should be doing” with their AD policies. Inasmuch, it is not always easy for a business planner to predict exactly when and by how much a given government or central bank will change its AD policies. Here is where knowledge about these issues is helpful to business executives. Keeping up with good analysis in the best magazines and newspapers often provides the clues as to what policy makers will do. There will ALWAYS be different opinions registered in these sources – but an informed opinion does often form that may be very influential.