Consumer and investor optimism and pessimism matter a great deal in the economy.

Question

Consumer and investor optimism and pessimism matter a great deal in the economy. Suppose that survey measures of consumer confidence indicate a wave of pessimism is sweeping the country.

If policymakers do nothing, what will happen to aggregate demand? What should the Federal Reserve do if it wants to stabilize aggregate demand? If the Federal Reserve does nothing, what do you think might Congress (fiscal policy) do to stabilize aggregate demand? Why do you think consumer and investor confidence affect AD and hence the economy?

Explanation / Answer

CCI is one of the important indicators that gauge how consumers interpret economic environment and their expectation for the future and declining can be one of the leading indicators of slowing economic activity.

Aggregate demand is the level of demand for desired good and services within national economy. This can be affected by variety of factors like consumer spending, investment, government spending and net export. This relation can be represented as YAD = C + I + G + NX   

Consumer spending is one of the biggest factor in AD and highly influenced by CCI

A family’s disposable income can increase or decrease aggregate demand, Disposable income is considered what a family has left after normal cost of living expenses are paid. When CCI goes down because of whatever reasons, families from all income buckets habitually spend less of their disposable income. Households look for lower prices and discounts and may wave a favourite brand for a cheaper brand. They tend to cut on their disposable income and park it for bad time and spend less in the fear of losing job or cut in their wage. These changes in consumer spending and behaviour would adversely impact aggregate demand if policy makers do nothing to bring consumer’s trust back in the economic condition.

Investor confidence is a high influencer on investment in the economy. With less trust in the economic conditions, government and Fed’s policies investor will be hesitant to invest in new business avenue, or expanding existing business hence decline in investment.

What can Fed do to stabilise the AD –

Federal can increase the money supply in the economy. If investors are not willing to invest then fed and provide the money at lower interest rate to them to ensure a better ROI on their investment. Higher money supply and lower interest rates in the economy will weaken the currency hence making export cheaper and import more expensive. This would improve next export and hence AD.

However money supply has a huge impact on prices too. In short run prices are sticky due to contracts, menu cost and uncertainty which insures for investors higher ROI on their investment due to sticky wage and input prices but in long run prices adjust to new cost of living and eroding this profit. So fed can compensate for drop in CCI with easy liquidity but at the cost of higher prices if CCI doesn’t improve in long run.

What can government do –

Government can increase the public spending – like building roads, dams or other infrastructure. This would not only add to AD but generate more employment, and hence add to disposable income and hence generate a possibility for increase in consumer spending. However in long run this would increase fiscal deficit and hence might lead to higher taxes in future.

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