Government Expenditure

This section explains Government Expenditure (G) covering, An Introduction to Government Expenditure, The Main Influences on Government Expenditure and Fiscal Policy.

Introduction to Government Expenditure

Government expenditure (G) is a crucial component of aggregate demand (AD) and refers to the total amount of money spent by the government on goods, services, and transfer payments (such as pensions, benefits, and subsidies). Government spending plays an essential role in influencing the level of economic activity, addressing market failures, redistributing income, and achieving macroeconomic objectives such as full employment, economic growth, and price stability.

This revision guide covers the main influences on government expenditure, focusing on the impact of the trade cycle and fiscal policy.

The Main Influences on Government Expenditure

Government expenditure is influenced by several factors, including the state of the economy (i.e., the trade cycle) and the government’s fiscal policy stance. These factors determine the level and nature of government spending at any given time.

The Trade Cycle

The trade cycle (or business cycle) refers to the fluctuations in the level of economic activity over time, typically characterised by periods of expansion and contraction. Government expenditure is heavily influenced by the phase of the trade cycle the economy is in.

• During an Economic Expansion (Boom): In a period of economic growth, when output is increasing and the economy is performing well, government spending may stabilise or even decrease. The government might choose to focus on reducing budget deficits, cutting public debt, or limiting expenditure to avoid overheating the economy. In such periods, there is typically less need for government intervention to stimulate demand.
• During an Economic Downturn (Recession): When the economy contracts, businesses cut back on investment, unemployment rises, and consumer confidence declines. In this phase of the trade cycle, government expenditure tends to increase as the government seeks to stimulate demand and support the economy. This is particularly relevant for counter-cyclical fiscal policy, where the government may increase spending on public services, welfare benefits, and infrastructure projects to boost economic activity and reduce the impact of the downturn on households and businesses.
• Automatic Stabilizers: Some government expenditure is automatic, meaning it increases or decreases in response to the state of the economy without the need for new policy decisions. For example, during a recession, more people may qualify for unemployment benefits, which increases government expenditure. Conversely, during periods of economic growth, fewer people may be reliant on benefits, reducing government spending.

However, the government may still increase spending on long-term projects like infrastructure development, education, and health services to support future growth, but in general, the focus will be on fiscal consolidation and managing inflationary pressures.

Governments may also adopt policies that directly increase household income, such as unemployment benefits or tax rebates, to support consumer spending.

Fiscal Policy

Fiscal policy refers to the use of government spending and taxation to influence the economy. The government can adjust its expenditure (G) to affect aggregate demand and stabilise the economy. Fiscal policy can be either expansionary or contractionary, depending on the economic conditions and policy goals.

• Expansionary Fiscal Policy: This policy involves an increase in government expenditure and/or a decrease in taxes to stimulate aggregate demand and support economic growth. Expansionary fiscal policy is typically used during periods of recession or economic stagnation to boost demand, reduce unemployment, and increase output. In such times, the government may invest in public sector projects such as infrastructure, education, and healthcare, or increase welfare payments to boost household spending.
• Contractionary Fiscal Policy: This policy involves a reduction in government expenditure and/or an increase in taxes to reduce aggregate demand and control inflationary pressures. Contractionary fiscal policy is typically used during periods of economic expansion or when the economy is overheating. The government may reduce spending on public projects or reduce welfare payments to cool down demand and manage inflation.
• Structural Budget Deficits and Surpluses: Governments may also aim to manage their structural budget deficit (the difference between government spending and revenue when the economy is at full capacity) or aim for a budget surplus (when government revenues exceed expenditures). This may influence their decisions on whether to increase or decrease government spending.

Example: During the global financial crisis (2008-2009), the UK government implemented expansionary fiscal policies by increasing public sector spending and reducing taxes to counter the recession and stimulate economic recovery.

Example: In periods of rapid economic growth and rising inflation, the government may decide to reduce public spending or increase taxes to prevent the economy from overheating and to maintain price stability.

Summary of Key Points

• Government Expenditure (G) is a component of aggregate demand (AD) that represents total government spending on goods, services, and transfers. It plays a key role in influencing overall economic activity.
• The Trade Cycle affects government spending in response to changes in economic conditions. In times of economic expansion, government spending may stabilise, while in a recession, the government may increase spending to stimulate demand and support the economy.
• Fiscal Policy refers to the government's use of taxation and spending to influence economic performance. Expansionary fiscal policy increases government spending to stimulate the economy, while contractionary fiscal policy reduces spending to control inflation.
• Government expenditure is influenced by the automatic stabilisers built into the economy (such as unemployment benefits), which change in response to the economic cycle without requiring new government intervention.

By understanding the relationship between the trade cycle, fiscal policy, and government expenditure, you can better analyse how changes in government spending can impact aggregate demand and the overall economic performance of the UK.