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
Best link to attack
Assumes: Government borrowing does not crowd out private spending.
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.
End
Real GDP growth rises in the short run. If the spending is on infrastructure or education, LRAS shifts right too, supporting long-run growth.
Time lag: spending decisions take time to agree, and large projects can take years to start, so the boost may arrive after the recession has ended.
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Questions this answers
- Assess the likely impact of an increase in government spending on economic growth.
- Discuss the effectiveness of fiscal policy in ending a recession.
- Explain how the multiplier affects the impact of an increase in government spending.
Diagram
AD/AS: AD shifts right from AD1 to AD2, and further to AD3 with the multiplier; real output rises from Y1 to Y3.
Reverse and related
Government spending cut (austerity) → AD falls → growth slows.