Fiscal Policy: Government Spending

After observing the effects of tax rates, we will move on to look at government spending, the multiplier and the impacts on specific macroeconomic objectives.

Another demand-side policy that comes under the fiscal branch is government spending. This is a lot simpler to understand, as Government Spending is a component of AD – an increase in G leads to an increase in AD, shifting the equilibrium outwards and increasing output.

Government Spending can come in various forms, but usually it refers to providing funding for various state-run sectors, such as education, healthcare, police, etc. This spending allows these sectors to grow and provide better services to the public, which improves the Quality of Life and Standard of Living of the general public. In addition, this allows these sectors to hire more workers and pay their current workers more. This increases the incomes of thousands of citizens, allowing them to spend more, which increases Consumption, another component of AD seen above. This increases output further. If more goods are being bought, firms gain more revenue, which they can invest – Investment yet another component of AD, increasing AD even more and thus economic output. If consumers are earning more income and buying more goods, and firms earn more revenue, this means more income tax, VAT and corporation tax. With this new increased revenue, the government can increase spending even further, repeating the cycle.

This is known as the multiplier effect, where the initial injection leads to a much larger increase in output, and depends on the marginal propensity to consume (we will cover the multiplier in more depth in a future article). The multiplier accelerates the growth caused by the initial government spending, and shows how effective it is at meeting this macroeconomic objective. However, it can increase AD too much, and so once the economy reaches full capacity, inflation will occur. This would then cause the government to reduce spending through contractionary fiscal policy, but this is an extremely controversial decision with severe political backlash.


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