Impact of Government Expenditures on Private Consumption
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Discuss the implications of a rise in government expenditures on private consumption behaviour.
The following paper will analyse the impact that government expenditure has on the household’s consumption behaviour. Prior to starting the discussion it is imperative to highlight that government expenditure is either in the form of building roads, railways etc. or by changing the level of taxes charged to the individuals in an economy. It is an undisputed fact that the primary economic objective at the micro level is to ensure that resources are efficiently allocated and on the macro level the objectives are mainly to ensure high and sustained levels of economic growth; maintaining low levels of inflation and unemployment and, finally, maintaining a stable level of exchange rate regimes.
Government expenditure is one of the tools of the fiscal policy which is used to bring the economy to its full employment level or the equilibrium level. The key indicator for growth in the economy is the Gross Domestic Product or more commonly known as GDP. GDP measures the domestic output in the economy, in other words the production of goods and services in the economy. There are have been various debates centred around the fact whether GDP should be considered a good indicator of growth or not; besides the area of measurement, many development economists also argue that the concept of growth does not take into account the human development side of the economy. In fact all GDP/ GNP (Gross National Product) are concerned about is the level of output.
Fiscal policy measures were proposed and Keynes’ to bring the economy out of the recessionary phase and help the economy achieve its macroeconomic objectives and stabilise the economy. However, in the 70s with the presence of stagflation, characterised by periods of stagnation and high levels of inflation, was not cured by fiscal policies as a result of which monetarism emerged and gained popularity. The idea behind increasing government expenditure is to stimulate growth in the economy.
Growth will only happen when there is sufficient demand for goods and services. Demand would only exist when people have the income to spend on the goods and services. Hence many a times in order to stimulate demand, government tends to increase create demand by engaging in activities which employs the under utilised resources. Recession is the result of negative or low economic growth. When there is a negative or low level of growth then the firms are forced to cut down on production, reducing levels of production then results in redundancies which lead to an increase in unemployment, therefore taking the economy away from its equilibrium level. Therefore, government expenditure increases the spending power of the households, when the income of the household increases they demand more goods and services. Greater demand creates a ripple effect of firms employing labour to meet the increasing level of demand, this leads to an increase in the production of goods and services, which further results in the rise in the economic growth levels.
Governments could increase the income by cutting the taxes charged. Prior to developing this point it is important to highlight that the consumption function which is generally the 45° line was suggested by Keynes. The following diagram depicts the consumption function.
Thus Keynes identified various factors on which a household’s consumption would depend, namely:
- Income, whether current level or anticipated level of income
- Amount of assets held
- Taxation – if the people anticipated that the taxes would decrease then the current spending would increase. This would also vary with the fact whether the anticipated decrease in taxes is going to be a long-term change or only for a short period.
- Consumer tastes and preferences – if the goods in the market do not appeal to the household’s preferences then their consumption levels will decline however and the opposite would be true if goods in the market would be as per the requirements of the consumers.
In the event that domestic production of goods and services does not meet the requirements of the consumers or the level of income increases up to a certain extent then the households would be more inclined to import goods. In this scenario the balance of payments situation could be in danger. Increase in import levels would mean that the budget deficit would increase therefore driving the domestic production of goods and services down. This would then result in the opposite which is economic growth would fall as import levels increase.
From the preceding paragraphs it can be concluded that a rise in government expenditure increases the spending power of the households and it therefore results in a rise in the growth levels. It has also been highlighted that the government has to ensure that in the light of increasing the growth levels it does it at the cost of achieving the opposite which is reduced levels of growth. For instance whilst higher levels of income increases consumer spending it also can have the negative effect of an increase in budget deficit thus the domestic economy would suffer. Moreover, the governments in the light of measuring economic growth should not simply stick to GDP as an indicator, primarily because it tends to ignore many other factors like the social costs, externalities like pollution and environmental affects and besides it may even widen the gap between the rich and the poor. The government thus has a major role to play in maintaining the balance between economic growth by increasing its expenditure levels. Thus in conclusion it can be said an increase in government expenditure stimulates economic growth in the economy by providing a higher level of income to the private households.
- Gwartney, James D., Stroup, Richard L., and Sobel, Russell S., Economics Private and Public Choice, (2000), Ninth Edition, The Dryden Press.
- Lumsden, K, Economics, (2003) Pearson Education
- Taylor, John B., Principles of Economics, (1998), Second Edition, Houghton Mifflin Company
- Todaro, M.P. and Smith, S.C., Economic Development, Eight Edition, Pearson Addison-Wiley (2003),
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