Ways in which government expenditure can give rise to inflation
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Question
Why might an increase in government expenditure give rise to inflation?
Answer
Government expenditure is a component of aggregate demand (AD), and it includes all government investment, consumption, and transfer payments in order to correct market failures, achieve supply side improvements and more. According to Keynesian economics, the long run aggregate supply (LRAS) curve is horizontal, upward sloping and then vertical. Since government expenditure is a component of AD, this means that if an economy is operating near or at full employment (at the vertical point of the LRAS curve) any increases in government spending will only be inflationary. The government also injects extra spending into the macro-economy as part of its discretionary fiscal policy. What results is demand which outstrips non-elastic short term supply. Suppliers will then increase their prices in order to meet this extra demand. This is an example of demand-pull inflation.
Another way that government spending can give rise to inflation is because of how government spending is financed. The government can directly inject money into the economy through quantitative easing. Quantitative theory suggests that if the government uses its monetary powers to print money, the rational economic agents will anticipate a depreciation of the currency’s value and price inflation. As such, these expectations for inflation will give rise to actual inflation.
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