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Why might an increase in government expenditure give rise to inflation?
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Solution
Why might an increase in government expenditure give rise to inflation?
The increase in the government expenditure can give rise to the inflation in some form. The government has the ability to capture the resources that are in scarce and deploy in the area where it lacks (Barro, 1987). This also does not require the government to act in consideration of the market. The increase in the inflation generally takes place when the competition in the market concerning resources increases. If the commodities are considered then it can be stated that whenever the particular commodity goes scarce, the prices of these go up and the consumers end up paying more.
The government expenditure can impact the inflation. The inflation can only takes place through government expenditure when there is shortage in the resources that are being dealt with. This was what one can understand the aspect from the demand side. If the supply side can be taken into consideration then it can be stated that when the supply of the money within an economy rises, then it is becomes a necessary condition where the prices of the goods will rise. The reason behind is the increased accessibility to money supply and no increment in the real value.
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The inflation occurs when the prices of the products and services rise up gradually. A constant and limited rise in inflation is considered to be as good for the economy.
If the government has increased the spending then it will impact the way labor and goods demand in the economy is operating. One might witness the wage inflation in the economy along with the price inflation. Moreover, it can be stated that the increase in the government spending can lead to the price inflation to some extent. However, the major reason behind the government spending is not the inflation but the focus on growing the economy. The purpose to improve the economy might go wrong if the government increases the money supply in the economy frequently then required.
The similar situation can arise if the private sector spending takes place. However, in these cases one aspect can be brought to the consideration that the spending does not have the direct impact on the supply of the money and, therefore, the impact on the inflation directly from the expenditure is not identified majorly (Gali et al, 2007).
If the spending is too generous only then it can be easily witnessed impacting the inflation. If the example of the US government spending is considered, then it can be observed that it has required constant induction from the government to keep the economic cycle running.
The justification of this situation can be that if the government makes the purchases (that is when it spends), then the cost of production goes up. This increase in the cost of production might push the product prices which eventually are stated as the inflation.The lower cost of borrowing is associated with the situation stated above and which might impact the interest rates in their real terms. Moreover, the situation can be good when the increase in the consumption due to the increased induction results in more investment in various growth aspects such as the infrastructures and production. The theoretical aspect has some resemblance to the real situations. However, due to the presence of numerous variables in the environment, one can witness less fruitful results.
One of the interesting aspects in the government spending is that if the government is spending excessively in the economy and extracting tax at the similar rate then it balances the overall spending (Anderson et al, 1986). However, there are situations when such concept fails to prove itself. One such situation is recession. In the recessionary times the consumers prefer to save their money which alternatively forces the private sector to start saving. In such situation, if the government tries to raise the tax, then it can be morally unsound and the government might face heavy protest.
There are supportive situation when the spending made by the government multiplies up and helps the economy grow on the back of the rising inflation (Christiano et al, 2009). It is a cyclic process. If the government spends, then it can lead to increase in the employment rate as the private sector will be able to pay more employees.
The increased employment and good salary will allow the individuals to spend more which will further boost the demand.
Therefore, in the end it can be stated that the government spending has mixed results for an economy. It particularly depends that in which state the economy is currently. The right conducive environment will add up to the economic growth, else it will have negative impact.
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Barro, R. J. (1987). Government spending, interest rates, prices, and budget deficits in the United Kingdom, 1701–1918.Journal of monetary economics, 20(2), 221-247.
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Anderson, W., Wallace, M. S., & Warner, J. T. (1986). Government spending and taxation: What causes what?.Southern Economic Journal, 630-639.
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Galí, J., López?Salido, J. D., &Vallés, J. (2007).Understanding the effects of government spending on consumption.Journal of the European Economic Association, 5(1), 227-270.
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Christiano, L., Eichenbaum, M., &Rebelo, S. (2009).When is the government spending multiplier large?(No. w15394).National Bureau of Economic Research.
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