Government Spending

Fiscal policy is the spending, taxation and borrowing undertaken by the government. The government control on taxation affects AD; by increasing taxation consumer spending and investment is likely to fall as consumers have less disposable income and firms have less retained earnings. Conversely if tax rates fall consumer spending and investment is likely to rise as consumers have more disposable income and firms have more retained earnings.

Government spending affects AD by increasing it if government spending rises or remains high and vice versa. Also if the government is spending a lot then people may become more optimistic about the future and so increase spending.

The fiscal stance of the government can either be expansionary where the aim is to increase the output of an economy or contractionary. Generally contractionary fiscal policies occur during an economic boom during fast and unsustainable growth.

There are 2 forms of government spending; automatic and discretionary. Automatic goes against the business cycle for example unemployment benefits and corporation tax. Unemployment benefits keep consumption up even during an economic trough. Corporate tax reduces consumption at high rates therefore reducing the economic peak. These are known as automatic stabilisers.

Discretionary government spending is where the government chooses to spend money for example by aiding first-time home buyers.

Government spending is an autonomous component of aggregate demand as certain spending e.g. national security will occur regardless of income accrued from taxes.

Page last updated on 20/10/13