Definition: The money spent by the public sector on the supply of public goods, services, and well-being of the society.
Effects of increasing government spending
Positives:
- Injects money into the economy – can increase output and prevent slowdown of growth
- Job creation – Direct public sector hiring for infrastructure such as hospitals and universities reduce unemployment
- Long-term productivity (output of goods and services) – Investing in education, research and development can increase the productive capacity of the whole economy
Negatives:
- Inflationary pressures – If the economy is already operating at full capacity, price level will suddenly increase drastically.
- Crowding Out Effect – For the government to fund high spending, they often borrow heavily, which can drive up interest rates making it more expensive for private firms (businesses) to borrow and invest.
- National Debt – Deficit-financed spending increases national debt, which can eventually lead to higher taxes or reduced public services to pay off interest.
Effects of decreasing government spending
Positives:
- Reduced Deficits and Debt: Lower spending shrinks the budget deficit, allowing the government to pay down national debt and avoid burdening future generations with high interest payments.
- Lower Interest Rates: With less government borrowing, there is less demand for loanable funds, keeping borrowing costs stable for private businesses and consumers.
- Fewer Distortions: It reduces the need for high taxation or large-scale borrowing, which can cause economic distortions or inefficiencies.
- Lower Inflation: By taking excess demand out of the economy, reduced government spending helps to temper demand-pull inflation.
Negatives:
- Slower Economic Growth: Government spending is a key component of GDP. Drastic cuts can lead to reduced real GDP and even trigger a recession, particularly if done during an economic downturn.
- Increased Unemployment: Reduced public sector activity and lower demand for goods and services can lead to job losses.
- Deteriorating Infrastructure: Chronic underspending limits investment in crucial areas like roads, public transport, and technology, lowering long-term national productivity.Poorer Public Services:
- Reduced funds often lead to the degradation of public goods, such as Healthcare and Education, which hurts social mobility and overall public welfare.
Government spending is a key component aggregate demand (AD) and is used to stimulate growth within the economy to increase the output of all goods and services.