Question

Describe the effect of government's cutting spending would most likely have on: (1) the aggregate demand curve (2) inflation (3) unemployment rate

Answer 1

1) Aggregate demand curve will shift to left.

Government Expenditure is an important tool of fiscal policy. Cutting down the government Expenditure means that government investment will be less. If government Expenditure on social security measures is reduced , it will lead to a fall in the income received by the marginalized sections of the society which will inturn lead to a fall in their consumption. If government Expenditure on Export promotion is reduced , it will lead to a decline in net Exports. Therefore , the four components of aggregate demand - consumption , investment , goverment spending and net Exports may fall . As a result there will be a declining in aggregate demand.

2) when government decreases the government Expenditure, money supply in the economy will be reduced. For example income that disadvantaged people get through government aid will be reduced. Government provided financial assistance to Industries will be reduced. A result in money supply leads to a decline in prices. We are also aware of the fact that, inflation in an economy is often demand driven. Since cut in Government spending curbs aggregate demand it will also be helpful in controlling demand pull Inflation.

3) Unemployment rate will increase.

The reduction in government spending is followed by a reduction in aggregate demand. When Aggregate demand falls, production will fall. As a result firms will find it unprofitable to employ more people leading to the dreaded job loss and loss of employment opportunities.