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, households and firms spend part of their extra income on imported goods and services.
marginal propensity to import
marginal propensity to import
Best link to attack
Assumes: The UK has a high marginal propensity to import.
Assumes: The UK has a high marginal propensity to import.
But: If the spending goes on domestic services, such as NHS staff, the import content is low.
6
In addition, if the extra demand raises UK inflation above that of trading partners, UK goods become less price competitive.
relative inflation · international competitiveness
relative inflation · international competitiveness
Assumes: UK inflation rises faster than inflation abroad.
But: With spare capacity, the extra demand causes little inflation, so competitiveness barely changes.
7
Therefore, spending on imports rises relative to export earnings.
current account
current account
Assumes: The exchange rate does not move to offset it.
But: If markets worry about government borrowing, as after the 2022 mini-budget, the pound can fall, making exports cheaper.
End
The current account deficit widens: the ‘twin deficits’ of a budget deficit and a current account deficit together.
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Questions this answers
- Assess the impact of expansionary fiscal policy on the current account.
- Discuss the relationship between a budget deficit and a current account deficit.
- Explain how an increase in national income might affect the trade balance.
Diagram
No standard diagram. The circular flow, with imports shown as a withdrawal, makes the link clear.
Reverse and related
Government spending cut → incomes fall → fewer imports → current account improves.