Government Spending on the Inflation Rate

Question: Discuss about theGovernment Spending on the Inflation Rate. Answer: Introduction Inflation is that condition where the prices of all goods and services rise. This means that the amount of money spent earlier in purchasing some goods or services cannot be enough to buy the initial quantity level of that good or service. The money loses its value mostly as a result of increased inflation rate. Inflation is one of the key indicators of economic growth. Some of the other key indicators include; unemployment, current account, trade. The level of the growth in an economy determines the policy action needed. Most policies are applicable when the economic growth is low. The policies are divided into two parts; they can either be fiscal or monetary. The fiscal policies involve the actions taken directly by the government. These are; a cut in taxes or an increase in government spending. The major role of these policies is to stimulate the economy's aggregate demand (AD) indirectly. There have been some challenges in the attempt to explain how the fiscal policies influence the inflation rate. Before the 1980s, the thought of business by the classical economics assumed that inflation was spurred by an increased government spending. This has however been disputed by the modern Keynesians (Green, 2013).Green argued that it could do cause inflation to rise, but this could be caused only by a real shortage in resources. It is important in this paper to note out that there are two types of inflation; one is the cost-push inflation arising from the supply side owing to increased production costs. The other one is the demand-pull inflation owing to the increased AD. The Operation of an Increased Government Spending The government may use the money it receives from tax, or it can borrow from other economies that are performing well. When it raises it spending, it causes an increased disposable income. The extra income is used in demanding extra units of the initial products or in demanding other goods or services. This raises the spending level in the economy. I.e. the AD in the economy is raised. When there is a demand shortage in the economy, this method is important, but its effectiveness is dependent on the economic state. During periods of very low economic growth, it becomes less effective because tax revenues are reduced. In order to get enough funding for the same, the government borrows from other economies. Fig: Demand-pull Inflation The period of production in the economy also determines whether the increase in spending will cause inflation. In the short-run, an increase in AD does not result in a price change since supply is elastic (almost horizontal). However, the supply curve is inelastic (almost vertical) in the long run; here, an increase in AD from AD1 to AD2 is inflationary (Economicshelp.org, 2016). I.e. cause price to go up from P1 to P2. Dupor (2016) and Beenhakker (2001) noted that during low economic growth, the government is prompted to raise its spending. The increased spending sometimes might cause the production costs to go up. Consequently, the producers are forced to raise the price of their goods or services. This cause the inflation rate to rise. The Federal Reserve is in such a situation forced to counteract with a restrictive monetary policy before the increase in inflation forces the interest rate to go down (Dupor, 2015). Lower interest rates lower the cost of borrowing. The households and businesses that avoided borrowing at the high-interest rate are now willing to borrow more; the unemployed get jobs. Their consumption of goods, therefore, rises (Pettinger, 2011). As per the law of demand, when it is high, the price level usually goes up. The figure below shows that in the real sense some level of government spending is important for the economy. It is this spending that results in improved infrastructure and quality of education. Despite the fact that government spending is crucial to the growth of the economy, it becomes a burden beyond certain levels. This now starts to make the growth rate fall with every increase in its spending. The curve above cuts the y-axis at 1; this proofs that at zero government spending there is no economic growth. The money used in financing the governments spending is taken either from taxes or from borrowing (Saville, 2008). The consequences for each source of funding is as follows. Additional taxation to raise tax revenue discourages production of goods or services; the lower the supply, the higher the price level. Borrowing may reallocate money to places where they are less profitable leaving the private investors with little money making the investment level to fall. How Inflation Results As noted earlier by Green, the spending by the government is directed towards those resources that seem to be scarce. If the short-term supply is non-elastic, an increased demand causes the price of the particular resource to go up. This argument was posed by Tarik Tristan Chardon (2013) in response to Greens argument. Tarik also noted that the means of funding the government spending also have a great influence on inflation. The governments expenses may be paid for by printing money as a form of monetary power. If this happened, the confidence of the economic agents would fall as they will anticipate a currency depreciation; the prices will escalate. John Craft (2011) argued that inflation may be caused by an accelerated growth of money supply by the central bank owing to an increased government spending. He noted that when the rate of money growth is higher than that of economic growth, inflation arises. Mulligan (2009) argued that there exist low correlation between the inflation rate and the government spending. He argued that it may not necessarily cause inflation. But he noted that high debts level for the economy may harm it and may be inflationary. Conclusion The spending by the government is important to every economy. It is agreeable that its increase may cause inflation if the government is not aware the point beyond which it should halt its spending. The state of the economy also determines whether the spending would stimulate the economic growth or not. The imposition of fiscal policies may sometimes call for an action by the monetary policies so as to make it effective. A governments spending may be too high, but its economic growth still lies behind. Policy Recommendations and Alternatives The government should consider the different states of the economy and understand which policy is better for every situation. It should also invest in research to find out the maximum level in which its spending should not exceed. It should also understand that high spending is not necessarily good for the economy. The means of funding the governments spending should be chosen wisely with considerations on the consequences being done. Cutting tax is the best alternative in stimulating economic growth. References Beenhakker, H. (2001). The global economy and international financing. Westport, CT: Quorum Books. Dupor, W. (2016). How Does Government Spending Affect Inflation? [Online] stlouisfed.org. Available at: https://www.stlouisfed.org/on-the-economy/2016/may/how-does-government-spending-affect-inflation [Accessed 22 Sep. 2016]. Dupor, B. (2015). The expected inflation channel of government spending in the postwar U.S. [online] Sciencedirect.com. Available at: https://www.sciencedirect.com/science/article/pii/S0014292114001494 [Accessed 22 Sep. 2016]. Economicshelp.org. (2016). Causes of inflation | Economics Help. [Online] Available at: https://www.economicshelp.org/macroeconomics/inflation/causes-inflation/ [Accessed 22 Sep. 2016]. Green, R. (2013). Does government spending spur inflation? [Online] quora.com. Available at: https://www.quora.com/Does-government-spending-spur-inflation [Accessed 23 Sep. 2016]. Mitchell, D. (2005). The Impact of Government Spending on Economic Growth. [Online] The Heritage Foundation. Available at: https://www.heritage.org/research/reports/2005/03/the-impact-of-government-spending-on-economic-growth [Accessed 23 Sep. 2016]. Mulligan, C. (2009). Inflation and Government Spending. [Online] nytimes.com. Available at: https://economix.https://economix.blogs.nytimes.com/2009/06/10/inflation-and-the-size-of-government/?_r=0blogs.nytimes.com/2009/06/10/inflation-and-the-size-of-government/?_r=0 [Accessed 23 Sep. 2016]. Pettinger, T. (2011). Impact of Increasing Government Spending | Economics Help. [Online] Economicshelp.org. Available at: https://www.economicshelp.org/blog/2731/economics/impact-of-increasing-government-spending/ [Accessed 22 Sep. 2016]. Saville, S. (2008). Government Spending and Inflation | Steve Saville | Safehaven.com. [FundOnline] Safehaven.com. Available at: https://www.safehaven.com/article/10688/government-spending-and-inflation [Accessed 23 Sep. 2016].