Question

Suppose growth in government spending in an economy permanently rises. Using the
AD-AS model, explain the effects of the permanent increase in government
spending growth on the inflation rate and the real growth rate in both the short run and the long
run.

Answer 1

Increase in public expenditure in the short run is inflationery in nature.Against the incrased government expenditure the current aggregate demand increases and aggregate supply remains the same it will lead to an increase in the general price level in the short run where the real growth rate remain the same.But one has to consder that if the economy is undergoing a recession that the current aggregate supply is more than the aggregate demand the public expendure in the short run will help in increasing money supply and increasing aggregate demand to the required levels without an inflation but there won't be any considerable impact on the real growth rate.

It has to be noted that the government expenditure generates income and that income will create demand for existing final goods and services of the economy leading to increase in the price levels i.e the inflation rates.

But in the long run a permanant increase in the public expenditure especially the capital expenditure leads to more physical and human capital formation which brings about an increase in aggrgate supply along with aggregate demand which is positive for the economy as it leads to increase in the real growth rate.Government expenditure complements to private investments bringing about more production and productivity leading to economic growth in the long run.