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Inflation refers to the persistent rise in general price levels. Not necessarily the high prices that constitute inflation but the rising ones. A small/sudden rise in prices may not imply inflation but possibly will reflect short-term workings of the market (Kim & Lin, 2012). Government spending, on the other hand, refers to expenses that the government incurs for the economy, the society, or for its maintenance. The increase in government spending will be inflationary only when the extra expenditure is more than what the standard functioning of the system can afford through taxation, public loans, or grants (Ruge-Murcia, 2013). The paper will focus on Keynesian and Classical theories to explain how an increase in government spending might give rise to inflation.
In the Keynesian view, an increase in either of the components of Aggregate Demand (AD) including the growth in government spending, (i.e., AD= G+ I+ C + X – M) gives rise to Demand Pull Inflation (DPI). The level of prices at full employment, just like the price of a commodity, is determined by the interaction between Price aggregate demand and aggregate supply.
In the figure on the next page, OP1 gives the price level at full employment. An increase in government spending shifts the demand curve outwards to AD2. The resultant rise in price (OP2) provides a mechanism where resources are reallocated from inactive sectors of the economy to more active ones. The only way for the government can have more resources at full employment, is by private entrepreneurs and consumers getting less.
It is important to note that increase in government spending can cause inflation at levels below full employment of output. It is best illustrated by the diagram below.
The aggregate supply curve (AS) rises upwards in the beginning but takes a vertical shape after full employment level (OYf) is reached. Assuming OY1 is the initial level of output, an increase in government expenditure will result to Y1 to Y2 rise in national output. Consequently, the prices will rise to Op2. The price responds to additional demand and rises further to OP2 if the consumers are unwilling to part with their claim (or when government expenditure continues to expand).
A price increase reduces the real consumption of wage earners (Hossain, 2014). Workers press for higher wages to compensate the rising cost of living. If their demand is granted, the cost of production rises, prompting producers to raise the prices. A further increase in prices increases the cost of living still further, and employees demand even higher wages. In this way, prices and wages chase each other as inflation gathers momentum. If unchecked, this may easily lead to hyperinflation where prices and salaries chase each other at fast speeds.
Modern monetarists, among them Milton Friedman, agree with Keynesians that inflation is a result of excess demand for goods and services. The difference between Keynesians and Monetarists’ view of inflation is that while Keynesians explain inflation as rising out of real sector forces, monetarists explain inflation on account of growing money supply in the economy ("The Demand-Pull Inflation (Explained With Diagram),” 2014). Monetarists believe that inflation is everywhere and always a monetary phenomenon brought by a more rapid in money supply than in output (Blaug, 2013). Given a full employment level, monetarists believe that a change in the quantity of money will lead to an equal-proportional change in price.
Monetarists believe deficit financing is a cause of inflation. When the budget expenditure exceeds the revenue, the government closes this gap with fiat money. The government may ask the federal bank to print more cash balances, which makes the money supply in the economy exceed the available goods and services, phenomena described as too much money chasing too few goods.
When the government tries to finance the expenditure through the printing of cash balances, money supply in the economy increases. The resulting situation is where there is excess money supply with the public over the demand. The households try to restore equilibrium by reducing the money balances through an increase in expenditure of goods and services. Thus, according to modern monetarists, an increase in the supply of real monetary balances increases the aggregate demand for goods and services. If there is no proportionate rise in output, then the excess cash balance leads to excess demand, which causes inflation.
Other Ways Government Expenditure can lead to Inflation
Government spending may be inflationary when it funnels vast sums of money into cartels such as higher education and skin care. The government by doing this supports directly the monopolistic pricing, which drives the prices higher, irrespective of whether the money supply is contracting or expanding.
Cost push inflation may arise when the value of the dollar goes down due to an increase in money supply. A decline in the value of the dollar about other foreign currencies makes the prices of imports rise, and this leads to cost push inflation.
It’s evident that a rise in government expenditure causes inflation out of real sector forces, increase in money supply, and cartel financing. The state of the economy will determine whether the method of financing government expenditure is inflationary or not. The closer the economy is to full employment, the more likely the new spending will lead to inflation. An economy in deep recession, low capacity utilization, and high unemployment of labor will be able to produce more goods and services due to increase in government spending. To that extent, government expenditure will be not inflationary but expansionary, or not as inflationary as it would otherwise be.
An increase in government spending financed by bond sales to companies and individuals is a viable option for printing more money. It causes no increase in money supply, bank reserves, or bank deposits. Government expenditure financed by taxation is neither inflationary nor expansionary; as the growth in government spending is counteracted by a reduction in private spending; thus minimal to no change in the aggregate expenditure.
Blaug, M. (2013). The Classical Economists Revisited. History Of Political Economy, 38(2), 398-400. https://dx.doi.org/10.1215/00182702-2005-010
Hossain, A. (2014). Monetary policy, inflation, and inflation volatility in Australia. Journal Of Post Keynesian Economics, 36(4), 745-780. https://dx.doi.org/10.2753/pke0160-3477360408
Kim, D. & Lin, S. (2012). Inflation and Inflation Volatility Revisited. International Finance, 15(3), 327-345. https://dx.doi.org/10.1111/j.1468-2362.2013.12001.x.
Ruge-Murcia, F. (2013). Government expenditure and the dynamics of high inflation. Journal Of Development Economics, 58(2), 333-358. https://dx.doi.org/10.1016/s0304- 3878(98)00117-5
The Demand-Pull Inflation (Explained With Diagram). (2014). YourArticleLibrary.com: The Next Generation Library. Retrieved 22 September 2016, fromhttps://www.yourarticlelibrary.com/macro-economics/inflation-macro-economics/the-demand-pull-inflation-explained-with-diagram/37994/
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