Increased Government Spending: The AD-AS Model

Executive summary

Government spending is a significant determinant of economic development. It greatly affects the direction and speed of the economic development of the country. The main source of funds for the expenditure is taxes. Government spending ensures the provision of essential services while addressing gaps in the market, the provision of essential infrastructure, and social support for the poor in society. It takes the form of transfer payments, current government spending, and capital spending. The AD-AS model is an effective tool for use in assessing the effect of increased expenditure on the economy. It takes into consideration the changes in the aggregate demand and the aggregate supply in the economy as a result of an intervention. The short-run effects would be a rise in AD and AS with crowding out of the private sector. The long-run effects would be the eventual diminishing of marginal returns on capital.

Increased Government Spending

Expenditure is a key component of any country’s economy (Forni & Gambetti 2016). It aims at addressing the social and economic roles of the government towards the population (Bergman, Hutchison & Jensen, 2016). The reasons for the spending are:

1. To ensure the provision of socially efficient public services and goods and address the challenges posed by the failure of the market to provide them.
2. To put in place a system of welfare support that acts as a safety net by supplementing the earnings of low-income households and the poorest individuals in society. The government does this by redistributing wealth and income among the population.
3. Provision of infrastructure through capital spending on health facilities, transport, and education. These areas are key indicators in determining the aggregate supply component of a country’s economy.
4. Government spending is a tool for managing the growth and level of aggregate demand to achieve macroeconomic policy goals such as high-level employment and low inflation.

Public expenditure accounts for nearly half of the United Kingdom’s GDP annually. It takes up three main forms as follows:

1. Transfer payments. Transfer payments are welfare payments that are availed through the social security system. These payments include jobseekers’ allowance, working families’ tax credit, child benefits, income support, state pension, and housing benefit. These payments provide and maintain a minimum standard of living that supports low-income households (Alesina & Passalacqua, 2016).
2. Current government spending. This involves the expenditure on the provision of recurrent services and goods by the state (Martin et al. 2015). It includes defence, state-provided education, and salaries for state employees such as those working for the NHS (Gibb et al. 2018).
3. Capital spending. This form includes amounts utilized on infrastructures like schools, motorways, hospitals, and roads (D’Agostino, Dunne & Pieroni 2016). Capital spending contributes towards the capital stock of the economy with significant supply and demand implications in the end.

The AD-AS model

Aggregate supply refers to the sum of all services and goods in the state’s economy that are available at various price levels. Aggregate demand, on the other hand, refers to the sum of services and goods in the economy that can be bought at various price levels. The normal behavior of an economy is that as the prices of services and goods change, price levels also change (Besanko, 2017). Consequently, businesses and individuals change the number of goods that they purchase (Besanko, 2017). The AS curve demonstrates the relationship that exists between output supplied and prices while the AD curve demonstrates the relationship between real Gross Domestic Product (GDP) demanded and price.

When the two curves are plotted together, the common curve demonstrates the AD/AS equilibrium of the economy. The point of intersection of the two curves demonstrates the equilibrium real GDP and the equilibrium price level of the economy. A shift in AD or AS thus has an effect on the price level and the real GDP. Short run macroeconomic equilibrium is achieved when the amount of GDP demanded is the same as the quantity that is supplied. This equilibrium is represented by the point at which the short term AS and the AD curves meet. In response, the price levels adapt to achieve equilibrium. Short term equilibrium does not always occur at full employment. On the other hand, long-run macroeconomic equilibrium is achieved when real GDP matches the potential GDP such that the economy is represented by the long term AS curve.

Effects of increased government spending

Short-run effects

The government increases its spending by increasing the yield of its various sources of income. Its main source of income is taxable. Thus, for the government to increase expenditure, it has to increase taxation (Roth & Wohlfart, 2019). The effect of increased government expenditure will, therefore, be negated by the rise in tax. As a result, AD would remain relatively constant. Despite this, there is still a chance that the increased tax and government spending could result in a larger GDP.

The economy would experience a recession, and as a result, consumers will decrease their spending. The private sector is likely to increase the amount of their savings. If the increased public expenditure creates jobs for the unemployed, they will have a larger disposable income that can be spent in the economy leading to a further rise in AD (Benigno, 2015). In such cases where the economy has spare capacity, government spending will result in a higher increase in GDP. If the economy is at its full capacity, higher government expenditure will crowd out the economy’s private sector causing no net change in AD since the only impact would be a switch from private to public sector spending (Benigno, 2015).

In the short-run, as the prices increase, the AS would also increase (Benigno 2015). This occurs because as prices increase, companies tend to increase output to capitalize on the increased profits. The response of the output to an increase in prices will be dependent on the current prevailing levels of production. If it occurs in the setting of fixed levels of output, the marginal costs incurred to produce extra will be significantly higher due to the limited spare capacity of the economy, factors of production and reduced returns on these factors. However, if potential output also rises such as in technological advancement, increased factors of production, AS would rise more significantly (Benigno, 2015).

Long-run effects

The Solow-Swan model is an exogenous model that explains the long-run economic impacts of an intervention by examining an increase in production, capital accumulation and labour growth (Durusu-Ciftci, Ispir & Yetkiner, 2017). The model assumes that marginal returns on capital eventually diminish and progress is dependent on technological advancement (Durusu-Ciftci, Ispir & Yetkiner, 2017). The short-run effects of increased government spending will result in steady-state investment to sustain the steady-state output, accompanied by a determined rate of depreciation and labour input growth.

In the long run, the rate of capital accumulation slows down and the output only grows at the rate of labour input (Durusu-Ciftci, Ispir & Yetkiner, 2017). The increased rate of saving results in a temporary increase in standards of living and capital intensity until the economy reaches a new steady state. This progress becomes dependent on technological advancement for progression to the subsequent steady-state.

Endogenous growth theories, on the other hand, propose that macroeconomic models are aggregates of microeconomic models. The growth of the economy will be due to incentives within the economy, human capital, and the availability of capital investment. In the long run, the increased inflation will lead to the continued accumulation of capital in the economy. The endogenous theory of economic growth therefore largely proposes that the growth of the economy is dependent on the quality of investment in knowledge, human capital, and innovation. Increased government spending will improve food production and quality, the quality of education and health available to the population, therefore increasing knowledge and the quality of human capital. Additionally, investment in the quality of human capital also stimulates innovation. These factors combined will lead to higher economic growth in the long run. This growth will be continuous and sustainable with continued investment in these areas.

Conclusion

Government funding can have a variety of effects depending on how the institution chooses to leverage its expenditure. Increased government spending will lead to more savings and a shift from the private sector to public sector investment in the short run. It will also result in a rise in the economy’s AS and AD. It will also lead to the development of social amenities, creating a conducive environment for the growth of private businesses. In the long run, it will lead to technological advancement and diminishing return on capital according to the Solow-Swan model. Based on endogenous theories, a rise in expenditure will lead to economic growth through improved quality of human resources, innovation, provision of incentives and capital accumulation.

Reference List

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