One of the key insights of macroeconomics is that the government can have a powerful influence on aggregate demand and that, in some circumstances, this influence can be used to improve economic performance.

The two main ways the government can influence the aggregate demand curve are through fiscal policy and monetary policy. We’ll briefly discuss their influence on aggregate demand, leaving a full-length discussion for upcoming chapters.

Fiscal Policy As we learned in Chapter 6, fiscal policy is the use of either government spending—government purchases of final goods and services and government transfers—or tax policy to stabilize the economy. In practice, governments often respond to recessions by increasing spending, cutting taxes, or both. They often respond to inflation by reducing spending or increasing taxes.

The effect of government purchases of final goods and services, G, on the aggregate demand curve is direct because government purchases are themselves a component of aggregate demand. So an increase in government purchases shifts the aggregate demand curve to the right and a decrease shifts it to the left. History’s most dramatic example of how increased government purchases affect aggregate demand was the effect of wartime government spending during World War II.

Because of the war, U.S. federal purchases surged 400%. This increase in purchases is usually credited with ending the Great Depression. In the 1990s Japan used large public works projects—such as government-financed construction of roads, bridges, and dams—in an effort to increase aggregate demand in the face of a slumping economy. Similarly, in 2009, in the wake of the Great Recession, the United States began spending more than $100 billion on infrastructure projects such as improving highways, bridges, public transportation, and more, to stimulate overall spending.

In contrast, changes in either tax rates or government transfers influence the economy indirectly through their effect on disposable income. A lower tax rate means that consumers get to keep more of what they earn, increasing their disposable income. An increase in government transfers also increases consumers’ disposable income. In either case, this increases consumer spending and shifts the aggregate demand curve to the right. A higher tax rate or a reduction in transfers reduces the amount of disposable income received by consumers. This reduces consumer spending and shifts the aggregate demand curve to the left.

Monetary Policy We opened this chapter by talking about the problems faced by the FOMC, the branch of the Federal Reserve that controls monetary policy—the use of changes in the quantity of money or the interest rate to stabilize the economy. We’ve just discussed how a rise in the aggregate price level, by reducing the purchasing power of money holdings, causes a rise in the interest rate. That, in turn, reduces both investment spending and consumer spending.

But what happens if the quantity of money in the hands of households and firms changes? In modern economies, the quantity of money in circulation is largely determined by the decisions of a central bank created by the government. As we’ll learn in Chapter 14, the Federal Reserve, the U.S. central bank, is a special institution that is neither exactly part of the government nor exactly a private institution. When the central bank increases the quantity of money in circulation, households and firms have more money, which they are willing to lend out. The effect is to drive the interest rate down at any given aggregate price level, leading to higher investment spending and higher consumer spending.

That is, increasing the quantity of money shifts the aggregate demand curve to the right. Reducing the quantity of money has the opposite effect: households and firms have less money holdings than before, leading them to borrow more and lend less. This raises the interest rate, reduces investment spending and consumer spending, and shifts the aggregate demand curve to the left.