Question

 

Graphically illustrate the effect of an increase in government purchases. Explain the government spending multiplier effect by using at least 200 words.

Answer 1

Government spending is an important component of the aggregate demand (AD). Increase in Government Spending Increases Aggregate Demand. Decrease in Government Spending Decreases Aggregate Demand. Therefore, Government spending is an important tool of fiscal policy aimed at stabilizing the Economy. Therefore, when the Economy is in Recession, Government spending is Increased so that Aggregate Demand could be increased. Similarly, when Economy is facing inflationary pressures, then the Government spending is reduced so that Aggregate Demand could be reduced.

However, Increase in Government Spending leads to increase in Aggregate Demand by an amount which is greater than the increase in Government Spending itself because of the working of the Multiplier effect. Government spending Multiplier is the number by which Aggregate Demand is increased when goverment spending is Increased by 1 unit. Multiplier works because as Government spends for any work, its Expenditure becomes somebody's income. Increases in somebody's income Increases her Consumption. Her Consumption spending becomes somebody's income and so on. This leads to an increase in Aggregate Demand which is far more Greater than Increase in Government spending itself. This is called the Government Spending Multiplier Effect. This effect is illustrated graphically in the graph below.