Question

illustrate the effects of an increase in government spending using the classical model assuming that money supply and tax collections are fixed and the government increases its expenditure by selling bonds to the public.

Answer 1

There are three ways government can increase its spending:-

( I ) Taxation

( II ) Selling additional bonds to the public.

( II ) Increasing the money supply.

However, according to the question taxation and money supply are fixed. Therefore, the increased government expenditures are assumed to be financed by selling bonds to the public.

A bond-financed increase in government spending will not affect the equilibrium values of output or price level. There will not be any effect on employment as well.

Let us understand it with the help of a diagram.

The diagram below shows the effect of an increase in government spending financed by sale of bonds to the public in the loanable funds market.

Ar equilibrium point E, the interest rate r₀ equates the supply of loanable funds, S, with the demand for loanable funds, I. Adding government deficit spending, ( G - T )_1, shifts the demand for loanable funds to the right. The equilibrium interest rate rises to r₁ at point F. The increase in the interest rate causes a decline in investment from I₀ to I_1, a distance B, and an increase in saving, which is an equal decline in consumption, from S₀ to S1, a distance A. The decline in investment and consumption just balances the increase in government spending.

Therefore, we can say that the increase in government spending has no independent effect on aggregate demand.