Question

Use the AD/AS model to show how increases in government spending can lead to more inflation.

Short answer

Inflation refers to the situation when the general price level in the economy increases. It leads to erosion in the value of cash holdigns as the purchasing power of money declines.

Step-by-step solution

Step 1. Inflation

Inflation refers to the situation when the general price level in the economy increases. It leads to erosion in the value of cash holdigns as the purchasing power of money declines.

Step 2. Basically, when government spending increases it results into rise of inflation as:-

a) When money in the market increases without increase in supply of goods then in that case it results into more money chasing a few output/goods i.e. the demand of goods increases without any increase in the output/goods.

b) When government spending focuses more on revenue expenditure without taking into consideration capital expenditure then again demand in the market increases without increase in the output. Thus, results into more inflation.