If you are looking for more A-level Economics essay and exam tips, check out the link below:
Government spending – key definitions and facts
Government spending is total spending by the public sector on goods and services.
Government spending is a component of aggregate demand (AD= C + I + G + X – M).
Examples of higher government spending
- Increase in government spending during the Covid-19 pandemic. For example, the UK Government spent £70 million on the furlough scheme (officially named the Coronavirus Job Retention Scheme). This gave money to firms in exchange for firms retaining employees on “furlough” at 80%.
- Government infrastructure spending projects, such as HS2 High Speed rail in the UK. HS2’s total cost is currently estimated at about £100 billion.
In 2022-23, the UK Government’s budget deficit was 100.6% of GDP. Source: Office for Budget Responsibility.
Advantages of higher government spending
- Higher aggregate demand. Government spending (G) is a component of aggregate demand (AD). So higher G boosts AD. So AD shifts right from AD to AD1. This raises real GDP from Y to Y1, raising the economic growth rate.
- Labour demand is derived from the demand for goods and services. So higher aggregate demand also boosts demand for labour, reducing the rate of unemployment.
- This can be particularly useful in a recession. In this case, higher government spending can aid recovery from recession and smooth out economic cycle. In a recession can reduce the extent of unemployment and prevent “hysteresis”.
- Multiplier effect. A one-off increase in government spending causes an even larger increase in aggregate demand and hence real GDP. So AD shifts further right from AD1 to AD2, boosting real GDP further from Y1 to Y2.
- Consider the example of government spending more on high speed rail. This money from the government goes towards construction companies to build the train tracks, which goes towards construction workers. These workers then spend the money in local shops, increasing consumption and incomes for local shopkeepers and so on.
- Fiscal-supply side policies can lead to productivity growth. High speed rail decreases geographical immobility of labour (quicker travel times means more jobs are in commuting distance for each worker). This shifts the long-run aggregate supply to the right, increasing real GDP and by lowering the price level, international competitiveness increases. For more on supply-side policies, see the link here.
- Inequality and poverty reduction. Welfare payments can improve the standard of living for those on low incomes or who do not do paid work. This can reduce the extent of poverty and inequality.
Drawbacks of higher government spending
- Higher inflation. Higher growth here comes with a tradeoff of higher inflation. As higher government spending boosts AD, the price level increases from PL to PL1. This can reduce the price competitiveness of exports, worsening the country’s current account.
- Crowding out. An increase in government spending can lead to a decrease in private investment.
- Higher government spending raises the demand for key inputs (including labour, raw materials and even loanable funds). So, the price of these inputs rises, increasing business costs. Hence some firms may cut back on investment. This may reduce the extent to which aggregate demand rises following higher government spending.
- See the diagram below. Demand for raw materials rises from D to D1. This raises raw material prices from P to P1.
- Use the first demand curve D, which represents private sector demand for raw materials. At the higher price P1, private sector demand falls from Q to Q2, reducing use of raw materials and associated private investment.
- A higher budget deficit. A budget deficit is when government spending exceeds tax revenue. A budget deficit increases the level of government debt, which leads to greater interest payments (“debt servicing” payments) on the debt.
- Interest payments come with an opportunity cost – rather than spending money on debt interest, the government could be putting that money towards other priorities like education or health.
- Higher government debt may lower the government’s credit rating, as investors may think the government is less able to repay debts.
- Lenders may ask for higher interest payments to cover this increased risk in future, raising government borrowing costs further. If a government cannot make debt repayments, they may have to stop making debt payments (“default”). This would make it very difficult for the government to borrow in the future.
- Higher taxes if the government does not want to increase the budget deficit. This can reduce aggregate demand. Also higher taxes can reduce incentives to work or grow a business, reducing the productive capacity of the economy.
Crowding out diagram
Evaluation points for higher government spending
The effectiveness of a change in government spending depends on:
- Size of multiplier. A small multiplier size means a smaller multiplier effect. The formula for the multiplier is 1/(1-MPC), where MPC is the marginal propensity to consume. A low MPC means that if a household sees an increase in income (by £1), consumption rises by a small amount only. This can occur where saving rates are high, taxes are high and/or there is a heavy reliance on imports. In these cases, a small multiplier reduces the size of the shift right in AD caused by higher government spending.
- The state of the economy, specifically the position on the Keynesian LRAS. For an economy at full capacity, a shift right in aggregate demand is only inflationary but does not raise real GDP.
- Level of interest rates on government debt. With low interest rates, borrowing is cheaper. So the size of debt interest payments falls, reducing the extent of any opportunity cost. The UK did have low interest rates from the 2008 recession into and including the Covid-19 pandemic. But interest rates have been rising to counter high inflation. So, while government borrowing may have been more appropriate in the pandemic, it is more costly as interest rates rise.
- What the government spends the extra money on. If the money is spent on welfare, it may reduce incentives to work, reducing productive capacity and growth.
- The position of the government budget. For example if the budget is in surplus, then raising government spending may not lead to a budget deficit and higher debt interest payments.
- The “rate of return” on government spending in terms of tax revenue. We know government spending can increase real GDP (higher real incomes). If that leads to an increase in tax revenues, that may partially offset the increase in the budget deficit over time.
- The debt-to-GDP ratio or more specifically the economic growth rate relative to debt growth. higher government debt may be sustainable if GDP is rising even more quickly. GDP reflects the ability of a nation or government to repay its debt, as higher GDP is likely to boost tax revenues.
Related questions
What are the main things that government spends money on?
Take the UK Government’s spending. The largest components of UK Government spending in financial year 2022/23 (source) are:
- Social protection – £327 billion. This includes pensions and unemployment benefit.
- Healthcare – £217 billion.
- General public services £168 billion, which includes debt interest payments.
- Economic affairs £128 billion. This includes fuel and energy subsidies as well as some business support payments.
- Education £108 billion.
This will obviously depend on the economy. For example the US may have different government spending priorities to the UK.
How does government spending cause inflation?
In a simple aggregate supply and aggregate demand model, government spending raises aggregate demand. This then leads to higher inflation.
In plain English, there is more “money” chasing the same number of goods and services.
But higher government spending may not always cause higher inflation. This depends on how much spare capacity the economy has, how the government funds spending and many other factors.
How is government spending funded?
Let’s assume the government starts off with a balanced budget where spending = tax revenue. Then, higher government spending can be funded in three key ways:
- Cutting other government spending items.
- Raising more revenue from taxes, often by raising tax rates.
- Government borrowing.
Related posts
For more on difficult A-level Economics topics, see the link below:
To see more A-level Economics resources, check out these links below:
A-level Economics Practice Papers
Economics Resources for A-level
About the author
