Government expenditure

Government expenditure is a relatively large and stable component of aggregate demand in most advanced economies, typically contributing between 30 to 40% to economic activity. Government spending as a proportion of GDP has increased over time, and tends to spike at times of military conflict, recession, and national crises such as the recent COVID-19 pandemic.

Government spending is an injection

Government spending is an injection into the circular flow of income, and in this simple model government spending is assumed to be autonomous, and independent of current GDP. In contrast, tax revenues going to the government are assumed to be a function of national income.

government spending is an injection into the circular flow of income

The reason for assuming government spending is fixed in any given time period is because this year's spending was decided in previous years - perhaps even decades ago.

Current and capital spending

Government spending may be used to fund capital projects, in which case it is referred to as capital spending, or to fund the wages of public sector employees, and other operating costs, in which case it is called current spending.

The purpose of government spending

  • Compensate for market failures - market failures occur when free markets do not allocate sufficient resources to the production of specific goods and service. Examples of failures include:
  • Failure to supply pure and quasi-public goods, including defence, police, street lighting, roads, parks, and bridges.
  • Failure to supply enough merit goods, such as healthcare and education.
  • Over-supply of demerit goods, such as alcohol and cigarettes.
  • Unregulated activities which generate harmful negative externalities.
  • Breakdown of spending by type or department

    government spending by department 2021
  • Fiscal policy – government spending may be used to inject new spending into an economy when private sector consumption or investment spending is insufficient to stimulate growth and employment. This may mean running a deficit budget, where tax receipts are insufficient to cover planned government expenditure. In this case, borrowing may be necessary to bridge the gap between revenue and spending. Ultimately, the purpose of fiscal policy is to smooth out short term fluctuations in economic activity. One of the weaknesses of this type of fiscal policy is that it can take a long time for it to have an effect.
  • Reducing inequality – government spending can be targeted at reducing inequality and 'levelling up'. In the long run, this can be achieved by spending in areas which have the largest impact on inequality of opportunity, such as education spending. Spending can also be targeted on a geographical basis, targeting areas with high rates of poverty.
  • Improving infrastructure – government spending can be directed towards infrastructure projects which as well as injecting spending into the economy will provide a longer lasting impact on the ability of the economy to supply. This, in turn, can help improve an economy's international competitiveness. However, critics argue that improvements in certain types of infrastructure simply encourage more travel and increased negative externalities.
  • Green technology – government can fund specific projects and technologies that lead to greener technology and a less polluted country. For example, investing in wind and wave power, and subsidising electric vehicle design, research, and production, and by providing charging points and charging infrastructure.

The effects of an increase in government spending

The effect of an increase in government spending partly depends on the kind of spending involved.

Current spending, on public sector wages, for example, may have a different effect than capital investment.

In all cases, increased government spending will increase aggregate demand, and shift the AD curve to the right.

Aggregate demand shifts to the right

government spending is an injection into the circular flow of income

This can increase GDP, and create inflationary pressure - depending on the responsiveness of aggregate supply.

Impact of inelastic aggregate supply

government spending creates more inflationary pressure of aggregate supply is inelastic

When aggregate supply is slow to adjust, and the AS curve is more inelastic - as with AS1 - there is a greater inflationary impact, with a smaller effect on real GDP.

However, an increase in capital spending, say on infrastructure or on technology (such as support for green technology projects) will increase productive capacity and shift the aggregate supply curve to the right.  This is likely to increase GDP, with less inflationary pressure than current spending.

Spending on capital goods shifts aggregate supply

government spending is an injection into the circular flow of income

Here, capital spending has shifted the aggregate supply curve to the right, resulting in non-inflationary growth.

Consumer spending

Consumer spending and aggregate demand

Consumer spending

How can taxes regulate consumption?

Supply-side policy

How effective is supply-side policy?

Supply-side policy