Question

In 2017, in proposing a \(\$ 1\) trillion increase in government spending on infrastructure, President Trump argued that the spending would increase total employment in the United States. a. Will increases in federal spending always increase real GDP and employment in the short run? Briefly explain. b. Are there circumstances in which the federal government would not want to increase its spending, even if the result was to increase real GDP and employment in the short run?

Short answer

Increases in government spending can increase real GDP and employment in the short run, but not always, especially if the economy is already at full employment. There can also be situations where the government would not want to increase its spending, such as due to concern over national debt or inflation.

Step-by-step solution

Understanding the impact of government spending

Infrastructure spending is a type of government spending that can boost the aggregate demand. In the short run, an increase in aggregate demand can increase the output, which is the real Gross Domestic Product (GDP), and employment. The reason is in the short run, prices are sticky or fixed, so any boost in demand leads to higher output and employment levels.

Government Spending Always Increasing Real GDP and Employment

While the general principle is that increased federal spending should increase real GDP and employment, it doesn't mean this is always the case. There are scenarios where this doesn't work. For instance, if the economy is already at full employment before the spending increase, instead of resulting in more output, the increased spending may result in an overheated economy, inflation, and could lead to economic decline.

Situations where Government Would Not Want to Increase Spending

Even if increased spending could increase real GDP and employment, there may be reasons why the government wouldn't want to do this. For instance, if the spending results in a significant increase in the country's debt, the long-term economic effects may be more harmful than the short-term benefits. Additionally, if the government has other policy priorities or if the measure is projected to cause a surge in inflation, it may choose not to increase spending.

Key concepts

Aggregate Demand

Aggregate demand represents the total demand for goods and services in an economy at a given time. When the government decides to increase spending, it directly affects aggregate demand. This is because government spending is part of the formula used to calculate it:

• Aggregate Demand (AD) = Consumption (C) + Investment (I) + Government Spending (G) + Net Exports (NX)

By injecting funds into the economy through increased government spending, such as on infrastructure projects, it can stimulate greater demand for inputs like labor and materials.
This boost tends to increase overall economic activity. More jobs are created as a result, and businesses experience higher sales.
However, it's crucial to remember that this increase in aggregate demand can have various consequences, depending on the existing economic conditions.

Real GDP

Real GDP measures the value of all final goods and services produced within a country, adjusted for inflation. It's a critical indicator of an economy's size and robustness. Government spending can lead to changes in real GDP.
In the short run, increased spending, especially on large projects like infrastructure, can raise real GDP. This happens because more production is needed to meet the increased demand, leading to higher output.
It is important to note that in the short run, prices are sticky. This means they don't immediately adjust to changes in demand. As a result, the initial outcome of raised spending is usually increased production rather than increased prices.

• Short-term: Prices are sticky, production increases, boosting real GDP.
• Long-term: As the economy adjusts, prices may rise, affecting the real GDP calculation.

Employment

Employment levels are intertwined with government spending and aggregate demand. An increase in demand for goods and services naturally leads to a demand for more workers to produce these goods and services.
Increased government spending often entails hiring additional workers for public projects. This can lower the unemployment rate. It's a tactic used by governments to create jobs quickly. However, when the economy is at or near full employment, new spending may not lead to significant increases in employment. Instead, it could result in higher wages and potentially inflation, as employers compete for the same workforce.

• Short-term impact: More jobs created.
• Full employment: Limited job creation, potential inflationary pressure.

Inflation

Inflation measures the rate at which the general level of prices for goods and services rises. When government spending jumps and aggregate demand follows, the economy might experience inflation if it cannot produce enough to meet demand without raising prices.
While a moderate amount of inflation is considered normal, too much can erode purchasing power and lead to economic instability. In situations where demand outstrips supply, prices rise. This is more pronounced in scenarios where the economy is operating at or near full capacity.
It's important for policymakers to watch inflation indicators, ensuring that increased government spending doesn't lead to unsustainable price levels. An overheating economy could prompt central banks to raise interest rates, which might curb inflation but also slow economic growth.

Fiscal Policy

Fiscal policy involves government decisions about spending and taxation. It's a fundamental tool for influencing economic conditions.
Through fiscal policy, the government can stimulate or cool down the economy by either increasing spending or adjusting taxes.
Spending more can shift aggregate demand outward, potentially boosting real GDP and employment. However, it can also increase inflation if not controlled.
There are times when increasing spending is not advisable, despite its benefits. For instance, if the economy is at full capacity, extra spending might only fuel inflation. Similarly, if the national debt is already high, more spending could be risky.

• Expansionary fiscal policy: Boosts growth, can lead to inflation.
• Contractionary fiscal policy: Slows growth, controls inflation.

The balance of fiscal policy involves weighing short-term economic boosts against potential long-term consequences, like debt or overheating.