Question

In Chapter3 and also in the growth model where we studied about the long run, deficit spending( a higher government spending for a given tax rate) appears to have a negative effect on the economy but in the IS-LM model we can see that the opposite is true. A higher G increases the GDP by enhancing demand. Which one do you think is true? Can you reconcile these two ideas? What is your conclusion in terms of practical policy?

Answer 1

                                    Government spending in an economy refers to the various ways in which the government would induce money in the economy to manage the economic issues within the nation and to implement various policy measures like budgeting. The following are the various effects of the increased government spending among the various economic sectors in the short-run and long run

· The increase in government spending is likely to cause an increased demand in the short run and thus is expected to have a positive impact on the economic growth in the short run.

· It is expected to lead to inflationary effects in the short-run if not controlled.

· It is expected to have an impact on the supply-side of the economy based on the sector in which the spending is being made. For example, if the increased spending occurs in the infrastructure segment, then it could lead to advancements in productivity and could lead to better growth in the long-run economy also

· The impact of government spending on the growth of an economy depends on the areas of investment. If more spending is done on welfare measures, then it is expected to reduce inequality and thus bring more people in to the economy, but it would lead to the rise of non-productive spending and thus may cause negative effects in the long-run economy

· An increased spending on healthcare is expected to bring long-term benefits to an economy, but may lead to short-term losses if calculated on the basis of GDP increase

· If the government has a higher rate of borrowing, then the increased spending would go to the investors and hence it would result in lower benefits for the economy in the long run.

· If the economy is close to its full capacity, then an increased government spending could lead to crowding out effects. This means that the spending has an effect of reducing private sector spending.

· The impact of government spending also depends on the state of the economy, If the economy is closer to its full capacity, then increased spending would cause only a smaller increase in the GDP and in recession, it would lead to lower improvements in GDP values

                                     From the above discussion, it can be seen that the impacts of a government spending on GDP depends on the various sectors and factors that affects the production rate within an economy. But, in general, it is believed that an increased government spending is expected to bring short-term benefits to an economy irrespective of the sector under consideration and long term benefits depending on the capacity of the sector in which the investment is being made.