Government expenditure
Definition
Government expenditure (G): spending by the state on public services and public sector investment, such as the NHS, education, defence and infrastructure.
- G is a major component of AD, around a quarter of the UK total, and unlike C and I it can be changed deliberately by the state to steer the wider economy.
- It spans day-to-day spending on public services and long-term public investment in infrastructure, so it affects both current demand and future capacity.
The trade cycle
Definition
Trade cycle: the fluctuation of real output around its long-run trend, moving through boom, downturn, recession and recovery.
Automatic stabilisers: forms of spending and taxation that change with the trade cycle without any new decision, raising spending in downturns and reducing it in booms.
- In a recession government spending rises automatically as more is paid out in unemployment and welfare benefits, which supports AD without any new policy decision.
- In a boom the same spending falls automatically as fewer people claim support, which cools AD, so stabilisers dampen the cycle at both ends.
Example
- In the 2008-09 recession welfare and unemployment spending rose automatically as more people claimed support, cushioning the fall in AD.
Fiscal policy
Definition
Fiscal policy: the deliberate use of government spending and taxation to influence the economy.
Expansionary fiscal policy: raising government spending (or cutting taxes) to boost AD.
Contractionary fiscal policy (austerity): cutting government spending (or raising taxes) to reduce a budget deficit.
- Because fiscal policy is discretionary, government priorities and the state of the public finances shape how much is spent each year, in contrast to the automatic changes above.
- A rise in G shifts AD to the right and a cut shifts it left, so fiscal choices feed straight through to the level of demand; the UK's austerity programme after 2010, for example, cut departmental spending to shrink the budget deficit and dampened AD.
Should government spending rise in a recession?
- It holds because higher G raises AD directly and, through the multiplier, by more than the initial injection, helping to close a negative output gap and cut cyclical unemployment.
- But it widens the budget deficit and, if financed by borrowing, can crowd out private investment or add to the debt burden carried by future taxpayers.
- On balance it depends on the size of the output gap and the state of the public finances: the case is strongest in a deep recession with spare capacity and weakest when debt is already high.
Exam technique
- Distinguish automatic changes over the trade cycle from deliberate fiscal policy choices.
- Link a change in G to the shift in aggregate demand it causes.
Common Mistake
- Do not confuse government expenditure with the budget deficit, which is spending minus tax revenue.
- The trade cycle changes spending automatically, whereas fiscal policy is a deliberate decision.
Self review
- What does government expenditure include?
- How does the trade cycle change government spending automatically?
- How does expansionary fiscal policy change government spending and AD?
