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, as the economy nears full capacity, firms compete for scarce workers and materials, so their costs rise.
positive output gap
positive output gap
Best link to attack
Assumes: The economy is close to full capacity.
Assumes: The economy is close to full capacity.
But: With a large negative output gap, as in a recession, extra demand raises output with little effect on prices.
6
Therefore, firms raise prices, knowing demand is strong enough that they will not lose many sales.
demand-pull inflation
demand-pull inflation
Assumes: Monetary policy does not respond.
But: The Bank of England may raise Bank Rate to offset the extra demand, a conflict between fiscal and monetary policy.
End
The rate of inflation rises.
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Questions this answers
- Explain how an increase in government spending might cause inflation.
- Assess the view that expansionary fiscal policy is inflationary.
- Discuss the possible conflict between economic growth and low inflation.
Diagram
AD/AS with a Keynesian LRAS: AD shifts right in the steep section near full capacity, so the price level rises more than output.
Reverse and related
Government spending cut → less demand pressure → inflation falls.