Aggregate Demand and Supply Model

Aggregate Demand and Supply Models

Shelly Spragens

ECO/372

May 6, 2013

Matthew J. Angner

Aggregate Demand and Supply Models

Economic Report for the President

        The following information is intended to give the president recommendations for government spending and taxes.  This is based on the current state of economic factors.  We will examine each of the following economic factors, unemployment, expectations, consumer income, and interest rates.  Below is information on how each factor affects the aggregate supply and demand.

Unemployment

        The BLS describes unemployment statistics in terms of a percentage. This percentage, referred to as the unemployment rate, is the percentage of people currently without work but are willing and able to perform job duties (Colander, 2010). Unemployment affects the economy through consumption. People without work spend less on goods and services, decreasing aggregate demand. Also when the unemployment rate is high the economy is not making use of all of its human resources, reducing the capabilities to perform at its potential. The BLS reports the current rate for individual states in March 2013 range from 3.3% - 9.7% with an average at approximately 7.6% (BLS, 2013).

Expectations

A variety of expectations affect aggregate supply and demand. Expectations of increased demand in the marketplace may induce increased production by businesses. The response of businesses to look for funding for expansion and growth increases the demand for investment, shifting the aggregate demand curve to the right (Colander, 2010). If expectations of future prices change, the demand for current priced items will increase, shifting the aggregate demand curve to the right (Colander, 2010). Expectations of inflation affect supply by shifting the SAS curve through wage changes (Colander, 2010). When workers expect prices to increase, they will demand higher wages in response (Colander, 2010). Expectations of unemployment can affect aggregate demand through consumption. Workers who fear losing their jobs in the future will be less likely to make large purchases and may increase savings, lowering their consumption and shifting the aggregate demand curve to the left. Conversely, a person who expects an increase in wages can finance purchases immediately, raising the demand for investment and shifting the AD curve to the right (Evans, 1999).

        Expectations are formed through general observations of the world we live in. Consumers form their expectations through input from media and word of mouth. Leading indicators such as GDP, the Consumer Price Index, and many others form perceptions, and expectations of future economic performance. One indicator that relates to aggregate demand is the Consumer Confidence Index (CCI). The CCI is based on a questionnaire that rates consumer perceptions of employment and business conditions (Trading economics, 2013). The current CCI is 68.1 and has fluctuated around that point for the past six months. For comparison, in 2007, and 2008 the CCI fluctuated above 100. We are currently seeing consumer confidence at much lower levels prior to our recent recession.

Consumer Income

According to the Associated Press, consumer income has seemed to have increased in the first quarter of 2013, despite the push-pull dynamic of an improving jobs market (push) and the introduction of new taxes (pull). The unemployment rate has dropped and the improving real estate market continues to translate into rising demand for homes, pushing house prices up and raising homeowners’ equity. These factors meant that despite an increase in the payroll tax on January 1 to finance new components of the Patient Protection and Affordable Care Act, after-tax income crept up by around 1% in March 2013. According to Bloomberg, the United States manufacturing has also rebounded this quarter from last, thanks to stronger capital investment and consumer spending. Since real output (manufacturing) is a corollary of real income (Collander, 2010), this spike in manufacturing would have translated to a comparable spike in income. According to the Department of Commerce, consumer spending rose 0.7% this quarter.

Interest Rates

        Since 2008, the Federal Reserve interest rate has remained between zero and a low 0.25 in a bid to encourage lending and spending. It is currently 0.25. The Federal Reserve has indicated that it intends to keep the rate within that margin, and only increase it when the unemployment rate drops to 6.5% (it is currently 7.7%).  In our current state of the economy the interest rates have been relatively low, which tends to stimulate capital investment and increase aggregate demand.
Recommendations

        The unemployment rate is currently above the desired level but has been decreasing in recent history. Government policies should aim to decrease the unemployment rate and increase consumer confidence. This can be achieved through expansionary fiscal policy shifting the aggregate demand curve to the right. This policy should include keeping taxes at a low rate and increasing government spending on products and services.

        Despite the encouraging 0.7% rise in consumption and 1% rise in income in 1Q 2013, the payroll tax rise may have dampened a continuation in this pattern as we head into Q2. A tax such as January’s however may spook households into channeling a larger portion of their income toward savings: this outcome ought to be avoided as it depresses consumption and may have a negative impact on jobs growth. Lower taxes on income create higher disposable income, increasing consumption, and demand. The response by businesses will be to hire more people and expand to keep up with the increased demand. By decreasing unemployment and increasing aggregate demand, providing businesses with more money for expansion will increase consumer and investor confidence and improve expectations about the future of our economy.

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