Learning Objective
Explain how government spending ( G ) fits into the circular flow of income, how it is used in fiscal policy, and evaluate its macro‑economic effects on output, employment, inflation and the external sector in both closed and open economies.
1. Basic Economic Ideas (AS‑Level 1.1‑1.6)
1.1 Scarcity and Choice
- Resources are limited; societies must decide what, how and for whom to produce.
- Opportunity cost – the value of the next best alternative foregone.
1.2 Economic Methodology
- Positive statements – describe “what is” (e.g., “An increase in G raises AD”).
- Normative statements – prescribe “what ought to be” (e.g., “The government should reduce inequality”).
- Use of ceteris paribus – all other things held constant when analysing cause and effect.
1.3 Factors of Production
| Factor | Definition | Typical Income |
|---|
| Land | Natural resources | Rent |
| Labour | Human effort | Wages |
| Capital | Produced means of production | Interest |
| Enterprise | Risk‑bearing & organisation | Profit |
1.4 Production‑Possibility Curve (PPC)
- Shows maximum output combinations of two goods when all resources are efficiently employed.
- Key features:
- Downward‑sloping – opportunity cost.
- Convex shape – increasing opportunity cost.
- Points on the curve = efficient; inside = under‑utilisation; outside = unattainable.
- Shifts:
- Outward shift – economic growth (more resources, better technology).
- Inward shift – war, natural disaster, loss of resources.
Diagram placeholder: PPC with arrows indicating a rightward shift.
1.5 Classification of Goods (Syllabus 1.5)
| Type of good | Ownership | Excludability | Rivalry | Examples |
|---|
| Private goods | Private | Excludable | Rival | Food, clothing |
| Public goods | State | Non‑excludable | Non‑rival | National defence, street lighting |
| Club goods | Private/State | Excludable | Non‑rival (up to capacity) | Gym membership, cable TV |
| Common‑pool resources | State/Community | Non‑excludable | Rival | Fisheries, forests |
| Merit goods | Often public | Usually excludable | Non‑rival (in consumption) | Education, vaccinations |
| De‑merit goods | Private | Excludable | Rival | Alcohol, cigarettes |
2. Demand and Supply (AS‑Level 2.1‑2.5)
2.1 The Demand Curve
- Downward sloping – law of demand.
- Determinants of demand: price, income, tastes, prices of related goods, expectations.
2.2 The Supply Curve
- Upward sloping – law of supply.
- Determinants of supply: price of the good, input prices, technology, expectations, number of sellers.
2.3 Market Equilibrium
- Intersection of demand and supply gives equilibrium price (P*) and quantity (Q*).
- Any shift in either curve creates a new equilibrium.
2.4 Elasticities
| Elasticity | Formula | Interpretation |
|---|
| Price elasticity of demand (PED) | Δ%QD / Δ%P | How much quantity demanded changes when price changes. |
| Price elasticity of supply (PES) | Δ%QS / Δ%P | How much quantity supplied changes when price changes. |
| Income elasticity of demand (YED) | Δ%QD / Δ%Y | Positive for normal goods, negative for inferior goods. |
| Cross‑price elasticity (XED) | Δ%QD of good A / Δ%P of good B | Positive for substitutes, negative for complements. |
Worked Example – PED:
If the price of petrol rises from £1.20 to £1.32 (a 10 % increase) and the quantity demanded falls from 100 million L to 90 million L (a 10 % decrease), then
PED = (‑10 %)/(10 %) = –1.0 (unit‑elastic).
2.5 Consumer and Producer Surplus
- Consumer surplus (CS) – area between the demand curve and the market price up to the quantity bought.
- Producer surplus (PS) – area between the supply curve and the market price up to the quantity sold.
Diagram placeholder: Demand‑Supply graph showing CS and PS.
3. Government Intervention (AS‑Level 3.1‑3.3)
3.1 Reasons for Intervention
- Market failure (public goods, externalities, information asymmetry, monopoly).
- Equity – redistribution of income and wealth.
- Macro‑economic stability – control of inflation, unemployment and growth.
3.2 Taxes and Subsidies
- Direct taxes – levied on income, profits, wealth (e.g., income tax, corporation tax).
- Indirect taxes – levied on consumption (e.g., VAT, excise duties).
- Incidence of an indirect tax – shown with a supply‑shift diagram; the burden is shared between consumers and producers depending on elasticities.
Diagram placeholder: Supply‑demand diagram with a per‑unit tax shifting supply left; indicate consumer and producer burden.
3.3 Price Controls
- Maximum price (price ceiling) – can create a shortage (excess demand).
- Minimum price (price floor) – can create a surplus (excess supply).
3.4 Redistribution Policies
- Progressive taxation, social security benefits, universal credit, minimum‑wage legislation.
- Evaluation criteria: equity, efficiency, administrative cost, impact on work incentives.
3.5 Case Study – Minimum Wage
The UK introduced a national minimum wage in 1999. Studies show:
- Higher wages for low‑paid workers (improved equity).
- Small reduction in employment in low‑skill sectors (possible efficiency loss).
- Spill‑over effects: increased consumer spending by low‑income households.
4. National‑Income Statistics & Circular Flow (AS‑Level 4.1‑4.6)
4.1 Key Concepts
| Concept | Definition | Relevance to G |
|---|
| GDP (Gross Domestic Product) | Total market value of all final goods and services produced within a country in a given period. | Expenditure approach: GDP = C + I + G + (X – M) |
| GNI (Gross National Income) | GDP + net primary income from abroad. | Shows income earned by residents, regardless of location. |
| NNI (Net National Income) | GNI – depreciation of capital stock. | Represents the amount of income available for consumption and saving after replacing worn‑out capital. |
4.2 Circular Flow of Income – Closed Economy
- Households supply factors of production and receive factor payments (W, R, P); they spend on consumption (C).
- Firms produce goods and services, receive revenue (C + I), and pay factor incomes.
- Government collects taxes (T), makes transfers (TR), and injects spending (G).
Diagram placeholder: Closed‑economy circular flow with arrows for factor payments, consumption, taxes, and G.
4.3 Open‑Economy Extension (Rest of World)
| Sector | Injections | Leakages |
|---|
| Government | G | T |
| Firms (investment) | I | S (saving) |
| Rest of World (ROW) | X (exports) | M (imports) |
National‑income identity for an open economy:
Y = C + I + G + (X – M)
Diagram placeholder: Open‑economy circular flow showing arrows for exports and imports.
5. Aggregate Demand and Aggregate Supply (AD/AS) (AS‑Level 4.4‑4.6)
5.1 Aggregate Demand (AD)
AD represents the total spending on a country’s output at different price levels:
AD = C + I + G + (X – M)
- Downward‑sloping because a lower price level increases real wealth, reduces interest rates, and improves net exports.
5.2 Aggregate Supply (AS)
- Short‑run AS (SRAS) – upward sloping; firms respond to higher prices by increasing output, but some costs are sticky.
- Long‑run AS (LRAS) – vertical at potential (full‑capacity) output; determined by factor endowments and technology.
5.3 Shifts in AD and AS
| Cause | Direction of AD Shift | Typical Effect on Output & Price Level |
|---|
| Increase in G (fiscal expansion) | Right | Higher output, higher price level (inflationary pressure if near LRAS). |
| Decrease in taxes (C‑boost) | Right | Same as above. |
| Rise in world interest rates (reduces I) | Left | Lower output, lower price level. |
| Improvement in technology | None (AS shift) | LRAS shifts right → higher potential output, lower price level. |
Diagram placeholder: AD/AS diagram showing a rightward shift of AD due to higher G, with movement from point A (equilibrium) to point B.
6. Government Spending (G) – Definition, Types & Budget Framework (Syllabus 5.2)
6.1 Definition
Expenditure by the state on final goods and services that directly satisfy public needs (e.g., roads, schools, defence) plus public‑sector wages and social‑security benefits.
6.2 Types of Spending
- Capital (investment) spending – long‑term assets such as infrastructure, hospitals, research facilities.
- Current (operational) spending – wages of civil servants, consumables, maintenance, welfare benefits.
6.3 Budget Components
- Tax revenue (T) – all compulsory payments from households and firms.
- Government spending (G) – as defined above.
- Primary balance = T – G (surplus if positive, deficit if negative).
- Public debt (D) – cumulative borrowing from previous years.
- Overall (fiscal) balance = T – G – r·D = ΔD, where r is the interest rate on existing debt.
6.4 Deficit, Surplus & Borrowing
- Budget deficit = G – T. Financed by net borrowing (B).
- Budget surplus = T – G. Allows repayment of debt.
- Borrowing (B) = ΔD + r·D (new debt issued plus interest on existing debt).
6.5 Interaction with Monetary Policy (Syllabus 5.3)
- Expansionary fiscal policy can raise interest rates if the central bank tightens money supply – the classic crowding‑out effect.
- In a coordinated policy mix, the central bank may keep rates low to reinforce fiscal stimulus.
7. The Fiscal Multiplier
7.1 Closed‑Economy Multiplier (no imports)
Assuming a constant marginal propensity to consume (MPC) and marginal propensity to save (MPS = 1 – MPC):
k = 1 / (1 – MPC) = 1 / MPS
7.2 Open‑Economy Multiplier (includes imports)
When imports rise with income, the marginal propensity to import (MPM) is added:
k = 1 / (1 – MPC + MPM)
7.3 Numerical Example
Suppose MPC = 0.75 and MPM = 0.15.
- k = 1 / (1 – 0.75 + 0.15) = 1 / 0.40 = 2.5.
- A £1 billion increase in G would raise equilibrium output by £2.5 billion.
7.4 Factors that Alter the Multiplier
- Higher MPC → larger multiplier.
- Higher MPM or higher marginal propensity to save (MPS) → smaller multiplier.
- Taxation on the additional income (e.g., a rise in income tax) reduces the effective multiplier.
8. Impact of Government Spending on the Economy
8.1 Short‑Run Effects
- Output & Employment – AD shifts right; higher real GDP and lower cyclical unemployment (movement towards full employment).
- Price Level – If the economy is below potential, the price rise is modest; near full capacity, demand‑pull inflation can emerge.
- Current Account – Higher income raises import demand, potentially widening the deficit.
8.2 Long‑Run Considerations
- Crowding‑out – Government borrowing can raise interest rates, reducing private investment (I).
- Debt Sustainability – Persistent deficits increase debt‑to‑GDP; high debt may raise future tax burdens and limit fiscal space.
- Supply‑side effects – Capital spending (e.g., transport infrastructure) can raise LRAS, offsetting inflationary pressure.
8.3 Timing (Lags)
- Recognition lag – Time to identify an economic problem.
- Decision lag – Time for policymakers to agree on a response.
- Implementation lag – Time to put the policy into action (e.g., tendering contracts).
- Impact lag – Time for the policy to affect the economy.
Because of these lags, fiscal stimulus may be mistimed relative to the business cycle.
8.4 Evaluation Checklist
| Benefit | Potential Cost / Limitation |
|---|
| Boosts AD quickly, reduces unemployment. | May cause demand‑pull inflation if economy near full capacity. |
| Capital projects can raise LRAS (long‑run growth). | High borrowing can crowd out private investment and raise debt ratios. |
| Targeted welfare spending improves equity. | Administrative costs; risk of creating dependency. |
| Stimulus can improve confidence (multiplier effect). | Effectiveness depends on size of multiplier – lower when MPC is low or MPM is high. |
9. Interaction with the International Sector (Syllabus 6.1‑6.5)
- Import multiplier effect – Higher G raises disposable income, increasing imports (M) and reducing the net impact on domestic output.
- Exchange‑rate regime:
- Floating – A larger current‑account deficit may lead to depreciation, which makes exports cheaper and partially offsets the import surge.
- Fixed – The central bank must intervene (buy foreign reserves) to maintain the peg; this can force a tighter monetary stance, enhancing crowding‑out.
- Policy mix – Coordination between fiscal and monetary authorities is crucial to avoid offsetting actions.
10. Suggested Diagrams (for revision)
- Closed‑economy circular flow (households, firms, government).
- Open‑economy circular flow (adds ROW, arrows for X and M).
- PPC with an outward shift.
- Demand‑supply diagram showing consumer and producer surplus.
- Supply‑demand diagram with an indirect tax – illustrate incidence.
- AD/AS diagram – rightward AD shift due to higher G.
- Fiscal multiplier illustration – series of AD shifts and resulting output changes.
- Current‑account impact – AD shift plus import response.
11. Key Take‑aways
- Government spending is a direct injection into the circular flow and a core component of the expenditure approach to GDP.
- Fiscal policy uses G (and T) to pursue macro‑economic objectives: growth, low unemployment, price stability, equitable distribution and external balance.
- The fiscal multiplier determines the size of the output effect; it is larger when MPC is high and MPM is low.
- Short‑run benefits (higher output, lower unemployment) must be weighed against long‑run risks: inflation, crowding‑out, debt sustainability, timing lags and adverse external‑sector effects.
- In an open economy the interaction between fiscal policy, monetary policy and the exchange‑rate regime shapes the final impact on national income.