Economics - Government Expenditure - Assessment Answer

January 08, 2017
Author : Ashley Simons

Solution Code: 1AEHH

Question: Economics

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Economics Assignment

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Economics

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Solution:

Introduction

The relation between increased government expenditure and rise of inflation is an issue of serious debate for long. According to Keynes, increasing government expenditure is one of the possible solutions during economic distress. But his claim on government expenditures to promote economic activities is not supported by all scholars. A group of eminent scholars especially the neo classical economists advocate that increased government expenditure may have depressing effect- it might slow down the aggregate performance of the economy. Moreover if government increases the borrowing in order to fund expenditure, then it would lead to crowd out the investment in private sector. Increased government spending is always a proposed solution to mitigate the economic downturn but it is associated with several adverse economic consequences.

This paper puts an attempt to gain an insight how increase government expenditure influence the inflation rate in the economy. With the application of economic theories, literature reviews and research studies, this recent study critically examines the real impact of government expenditure on inflation.

Analysis

 The effect of increased government spending during economic downturn: historical evidence

The government usually funds the public expenditure in three primary sources:  either through direct taxation, by borrowing or by inflation. The direct taxation is not a politically acceptable solution during the period of economic distress. But the end result of increased government spending is the reduction of wealth within the economy. Historical evidence clearly shows that increased government spending failed to catalyze the sustained economic growth in US during 1920s and 1930s. Japan is another prominent example where increased government spending ultimately led to prolong the economic contraction rather than mitigate the downturn. During 1990s, Japan experienced mounting public debt due to heavy public expenditure aiming to stimulate the economic activities but the strategy is proved to a big failure.   Thus increased government spending cannot possible help always. Sometimes it likely to prolong the economic downturn – if the situation is getting worsened with the first round of fiscal stimulus, then new fiscal stimulus package is proposed and arranged that even does more harm to the economy (Saville S, 2008) .

Impact of increase in government expenditures: Macroeconomic perspective

The macroeconomic perspective of increased government expenditures can be analyzed through aggregate demand and aggregate supply analysis. When the economy is in recession, an increase in government expenditures stimulates aggregate demand since government expenditures are a key component of aggregate demand. Thus increase in government expenditure is an important expansionary fiscal policy tool to stimulate economic growth in the short run. But in the long run, if the economy is at full employment level, any further increase in government expenditures will be highly inflationary.

Economic theory explains the relation between the growth rate and government spending as a percentage of GDP with the help of RAHN curve.  Some government spending is very much essential for successful operation but if government grows too big the economy ultimately shrinks. Academic research indicates that US is now at the downward portion of RAHN curve like many other industrialized nations. Policy makers can enhance the economic performance by reducing the size and scope government (Daniel J. Mitchell, 2005).

How Government spending affects inflation:

Government spending is recognized as an important expansionary fiscal policy tool commonly used to stimulate the aggregate demand and thereby boost economic performance of any economy. When the economy becomes weak and feeble, there is a renewed call for increase the new fiscal stimulus.  New government spending might drive up the inflation.  As long as Fed does not counteract with tightening monetary policy, it would drive down the real interest rate. Lower cost of borrowing would encourage both consumption expenditure and investment expenditures and thereby stimulate the economy. This is considered as an interesting theoretical mechanism where government spending might influence the output indirectly by affecting inflation, though there is little empirical evidence. Actually, economists across the board have found little rather no relation of government spending on inflation. According to their estimation a 10% rise in government spending would lead to 8 basis point decline in inflation. They strongly advocate that inflation channel of government spending should not be given any importance if the government expenditure is found essential to affect the economic performance ( Dupor W, 2016).

Inflation and government spending: a weak correlation

Though it is claimed that high inflation occurs as a consequence of excessive government spending, various real life examples confirmed that they are weakly correlated, if correlation exist at all. Federal Reserve Board’s Song Han and Casey B. Mulligan (2008) has pursued a research study on 80 countries and observed the correlation between inflation rate and government expenditure is not much strong. Their research study has found the inflation rate of the countries that spend much on non- military  sectors are similar or even less than the countries whose  government spent less. But their study observed a significant positive correlation between government expenditure and inflation rate only in case of military spending – as it usually happens during wartime (Casey B. Mulligan, 2009).

 

Conclusion

There have been extensive research and empirical study that attempts to focus on the relation between government expenditure and inflation both in the context of developed and developing nations. Mohsen Mehraraa , Mohsen Behzadi Soufiani ( 2016) , in their research study examines the non- linear relationship between government expenditure and inflation with the help of quarterly data ( 1990-2013) by using the econometric tool of Smooth Transition Regression Model. Their research study observes that the impact of government expenditure on inflation largely depends on the monetary conditions. In case of low liquidity growth of first regime, increase in government expenditures is not at all inflationary even it may have a negative impact of inflation. But government spending is found to be inflationary in case of high liquidity growth regime (Mehraraa M  &  Soufian M B , 2016).

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