ChainWhat it assumes · how to break it
Start
The government raises its spending, for example on infrastructure and public services, without raising taxes.
1
As a result, since government spending is a component of aggregate demand, AD shifts to the right.
AD = C + I + G + (X − M)
AD = C + I + G + (X − M)
Assumes: The spending is new money, not paid for by higher taxes.
But: If it is financed by higher taxes, consumption falls and offsets much of the rise in G.
2
This means firms supplying the government, such as construction firms, receive more orders, raise output and pay out more in wages and profits.
injection into the circular flow
injection into the circular flow
Assumes: Firms have spare capacity to raise output.
But: If the economy is near full capacity, firms cannot raise output much and raise prices instead.
3
Consequently, the workers and firms receiving that income spend part of it, which becomes income for others, who spend part of it in turn.
multiplier · MPC
multiplier · MPC
Assumes: The marginal propensity to consume is high.
But: In an open economy with high taxes, much of each round leaks into imports, tax and saving, so the multiplier may be little above 1.
4
Therefore, AD rises by more than the original spending, and real output rises.
multiplier effect
multiplier effect
Assumes: Government borrowing does not crowd out private spending.
But: If heavy borrowing pushes up interest rates, private investment falls and offsets part of the rise in AD.
5
As a result, since labour is a derived demand, firms need more workers to produce the extra output, and the public sector itself may hire more staff.
derived demand
derived demand
Best link to attack
Assumes: Firms hire rather than use existing staff more.
Assumes: Firms hire rather than use existing staff more.
But: Firms that hoarded labour in the downturn can raise output by working existing staff harder, so hiring lags.
6
This means firms advertise vacancies and take on the unemployed, so demand-deficient unemployment falls.
cyclical (demand-deficient) unemployment
cyclical (demand-deficient) unemployment
Assumes: The unemployed have the skills the new jobs need.
But: If spending is concentrated in sectors such as construction, the jobs may need skills the unemployed lack, so structural unemployment remains.
End
Unemployment falls.
Can you say this chain from memory?
Members can hide the links, test themselves and track which chains they have mastered.
Practise this chainMembers can hide the links, test themselves and track which chains they have mastered.
Questions this answers
- Explain how an increase in government spending might reduce unemployment.
- Assess the effectiveness of fiscal policy in reducing unemployment.
- Discuss whether demand-side policies can reduce all types of unemployment.
Diagram
AD/AS: AD shifts right towards full employment output; or labour market: labour demand shifts right.
Reverse and related
Government spending cut → public sector job losses and weaker demand → unemployment rises.