Question

Explain the effect of the government’s increased expenditure on infrastructure on U.S. aggregate demand and aggregate supply. The government’s increased expenditure on infrastructure _________ in the short run and _________ in the long run.

Answer 1

The effect of the government’s increased expenditure on infrastructure on U.S. aggregate demand and aggregate supply is-

Fiscal policy concerns the usage in the amount of Government spending (G) and Taxation (T) to influence the national economy. This policy can affect both Aggregate Demand (AD) and Aggregate Supply (AS), though it is worth noting that the affect on AD is much more direct and immediate, whereas AS is affected through indirect means over a greater period of time. It is also just about impossible to isolate the two effects - any change in fiscal policy will ultimately affect both AD and AS.

AGGREGATE DEMAND & AGGREGATE SUPPLY-

We know that, AD = C + I + G + (X - M) where 'G' stands for government spending. Taxation is accounted for in the affect it has on the other components of aggregate demand

Increases in government spending will increase aggregate demand, which will have affects on the economy overall. It leads to an increase in output and average prices, other things being equal. However, the degree to which output/prices rise depends on the elasticity of AS

If Aggregate Supply is elastic, a large increase in output may result with little risk of inflationary pressures. However, if AS is inelastic increased government spending may not be the best way of boosting the economy, as it is at risk of 'overheating' - that is, at risk of causing inflation rather than growth in output.

This can be easily shown on an AD-AS diagram:

( DIAGRAM IMAGE IS GIVEN AT THE BOTTOM OF THE ANSWER)

EFFECT OF GOVERNMENT'S INCREASED EXPENDITURE ON INFRASTRUCTURE ON AGGREGATE DEMAND AND AGGREGATE SUPPLY -

Increased government spending is likely to cause a rise in aggregate demand (AD). This can lead to higher growth in the short-term. Higher government spending will also have an impact on the supply-side of the economy depending on which area of government spending is increased.

Some of the points are explained below-

(1) CAPITAL SPENDING - Government spending on infrastructure, such as new transport networks, increases the potential output of an economy. Also, lower corporation taxes mean that businesses can invest greater sums at the same time, contributing both to AD and AS. Capital spending could also include investment in 'human capital', such as retraining, higher education and vocational training as ways to increase the supply of labour, reduce unemployment and provide a more productive workforce.

(2)WELFARE BENIFITS – this spending will help to reduce levels of inequality. There is potential higher welfare benefits could reduce incentives to work, but on the other hand

(3) PENSION SPENDING – ageing population, requires higher government spending, but this has no impact on boosting productivity

(4) INFRASTRUCTURE INVESTMENT - Higher spending on roads and railways can help remove supply bottlenecks and enable greater efficiency. This can also boost long-term economic growth

(5) WORKFORCE INCENTIVE- Changes in the benefits system, such as a reduction in income tax, could create greater incentive for individuals to return to work. This increases labour supply, and hence overall supply as labour is a factor of production. It could be argued that welfare and benefit reform is more important ie. fewer benefits for the unemployed to incentivise them to work.

ANSWER OF SECOND PART OF THE QUESTION-

The government’s increased expenditure on infrastructure INCREASES in the short run and DECEASESin the long run.