This paper is on the topic of Government Expenditures and Revenues, Budget, National Debt. The first part of this paper will discuss the effect of government purchases on aggregate demand. The second section of this paper will discuss the shift in aggregate demand curve and change in GDP in comparison to aggregate demand curve, on the bases of factors like government purchases, GDP and the multiplier. The Final section of this paper will discuss the issue of crowding out and its implications on fiscal policy changes.
Government Expenditures and Revenues, Budget and National Debt
Yes, all government purchases have the same effect on the aggregate demand curve.
/> Any change in the government purchases with other things remaining unchanged, the aggregate demand is affected. Increase in the government purchases increases the aggregate demand; and decreases in the government purchases decreases the aggregate demand.
AD = C + I + G + NX
Here, AD= Aggregate demand; C= Consumption; I= Investment; G= Government Purchases; NX= Net Exports
Economists have argued that reductions in the defense spending during the fall of Soviet Union (USSR) in 1991 led to reduction in aggregate demand. In same way, when defense spending was increased during Afghanistan and Iraq wars the aggregate demand was increased. Extensive increase in the duration of World War II led to increase in defense spending which accounted in an increase in aggregate demand. When aggregate demand decreases due to less spending from business sectors or households, the government purchases are increased to ensure the balancing of aggregate demand. Similarly, when aggregate demand increases to the level of causing inflation the government spending tend to be less. So, when the government purchases increases, due to the increase in defense spending the aggregate demand increases. This will shift the aggregate demand curve to the right. The government purchases element of aggregate demand comprises of all purchases made by the government agencies on goods and services made by firms and direct production from the government agencies themselves. When the federal government buys some staplers and staples, this transaction is part of the government purchases. Any production of research and education services by public universities and colleges is also accounted in the government purchase component of GDP. Also, any increase in the government spending on highways leads to increase on the government purchases. All these actions have the same impact on the aggregate demand curve, as it shifts to the right.
Shift in Aggregate Demand Curve
AD = $ 100 billion * 1.5 (multiplier)
AD= $ 150 billion
The effect of increase in government purchases by $100 billion, where the initial equilibrium real GDP is $5,000 billion and the multiplier is 1.5. The $100 billion increase in the government purchases will increase the total quantity of goods and services by $ 150 billion ($100 billion multiplied by the multiplier) to $ 5,150 billion. This increase in government purchases will shift the aggregate demand curve to the right.
The change in the Real GDP will be the increase in aggregate demand. In this case, the Aggregate demand curve will shift from $100 billion to $ 150 billion that is a 50% increase in the aggregate demand. The real GDP in this case will change by $5,000 billion to $5,150 billion (addition to the aggregate demand), that is only 3% increase in the real GDP. Thus, the change in Real GDP is much smaller than the change in aggregate demand.
Crowding Out is an effect which takes place when the government finances their spending with tax collected or/and the deficit spending, which leaves the businesses with lesser money effectively crowding them out. An explanation of behind crowding out happens when government finances projects through the deficit spending via using borrowed money. The government borrows large amount of capital, which increases the interest rates. This higher interest rate discourages the businesses from borrowing, reducing their investment and spending activities (Investopedia). The increased interest rates lead in reduction of private investments and spending which dampens the initial increase in the total investment and spending, this called crowding out. In some cases, government chooses an expansionary fiscal policy by increasing their spending for boosting the economic activity which in turn increases the interest rates. The increased interest rate affects the decisions of private investment. A higher scale of crowding out might even lead to reduction in income in the economy. With higher interest rates, costs for funds for investment also increases and affects its accessibility to debt-financing mechanisms. This leads in reduction in investment which ultimately crowds out the effect of initial rise in the overall investment spending. Usually, the initial increase in the government spending gets funded with high tax or borrowing by the government (The Economic Times). When the economy operates at near capacity, government borrowing for finance increases the deficit resulting in higher interest rates. The higher interest rate crowds out or reduces the private investment leading to lower growth rate. ‘Crowding Out’ explains how large and sustained government deficits take its toll on growth by reducing the capital formation (Tyson, 2012).
Crowding out leads to reduction in effectiveness of expansionary fiscal policy, whether it is increase in the government purchases, transfer payments and/or reduction in income tax. All these policies increase the deficit leading to increase the government spending. The supply of bonds rises, interest rates increases, investments decreases, exchange rates increases and net exports decreases, which lead to private investment being crowded out. The expansionary fiscal policy can take the form of increase in investment component of the government purchases. Some of the government purchases are on goods like office supplies and other services. But, the government can also buy investment products, like schools and roads. In such case, government investment might crowd out the private investment. As the expansionary fiscal policy either decreases revenues or increases the government spending, it decreases the surplus or increases government budget deficit. A contractionary policy is likely to increase surplus or reduce the deficit. Fiscal policy which increases the government purchases, increases transfer payments or reduce taxes – or do combination – all have the possibility to raise the real GDP. Government needs to decide which sort of fiscal policy to employ. Politicians are mostly the decision makers who decide the fiscal policy; the choice of policy options is extremely political matter that reflects the ideology of political leaders. Example: politicians who believe that government is quite large will argue for tax cuts for closing the recessionary gaps and for cutbacks in spending for closing the inflationary gaps. Politicians who believe private sector has failed for providing sufficient sources for the benefit of the society like public transportation and better education, seems to advocate increase in the government purchases for closing recessionary gaps and tax increases for closing the inflationary gaps. Another policy objective comes from politicians who believe that fiscal policy needs to be constructed for promoting long-term growth. The supply side economists advocate reduction of tax rates for encouraging people to work more and provide investment tax credits for stimulating capital formation.
All government purchases have the same effect on the aggregate demand curve. Increase in the government purchases increases the aggregate demand; and decreases in the government purchases decreases the aggregate demand. This increase in government purchases will shift the aggregate demand curve to the right. An explanation of behind crowding out happens when government finances projects through the deficit spending via using borrowed money. The government borrows large amount of capital, which increases the interest rates. This higher interest rate discourages the businesses from borrowing, reducing their investment and spending activities.
Tyson, L.D. Confusion about the Deficit. Retrieved 3 Feb 2014 from,
Definition of 'Crowding Out Effect'. Retrieved 3 Feb 2014 from, http://economictimes.indiatimes.com/definition/crowding-out-effect
Crowding Out Effect. Retrieved 3 Feb 2014 from, http://www.investopedia.com/terms/c/crowdingouteffect.asp