Aggregate demand is a measure of the total consumption of goods and services over any time period, and is the most important ingredient that can be targeted by the government through fiscal or monetary policy.

How the Fed Impacts Aggregate Demand

The Federal Reserve’s direct effect on aggregate demand is mild, although the Fed can increase aggregate demand in indirect ways by lowering interest rates. When it lowers interest rates, asset prices climb. Higher asset prices for assets such as homes and stocks boost confidence among consumers, leading to purchases of larger items and greater overall spending levels. Higher stock prices often lead to companies being able to raise more money at cheaper rates.

The mandate of the Fed is to balance the competing goals of employment and price levels. However, aggregate demand is an important component in both of these measures. Therefore, the Federal Reserve is deeply concerned with it. When resources are constrained and there is an increase in aggregate demand, inflationary risks increase. If total consumption of goods and services in the economy decreases, then businesses have to let go of workers in response to the declining revenue.

Fiscal Policy and Aggregate Demand

Fiscal policy is a much more direct way to affect aggregate demand as it can put money directly in the hands of consumers — especially those who have the greatest marginal propensity to spend. This increased spending leads to positive spillover effects such as businesses hiring more workers.

Some typical ways fiscal policy is used to increase aggregate demand include tax cuts, military spending, job…