Part II: Macroeconomics
Increased Government Spending
When the government increases its spending, it uses tax revenue to increase aggregate demand. If the government’s
budget is balanced at the outset of spending, an increase in spending creates a deficit (in this case, spending in excess of
tax revenue). Figure 5-1 illustrates the effect of government spending on aggregate demand.
Figure 5-1The government spends money on national defense, roads, education, and other parts of the economy. Transfer pay-
ments, or government payments to households (social security, welfare, Medicare, veterans payments, unemployment
compensations), are not included in government purchases. Paying for expenditures becomes a daunting task in some
cases for the government. Increased tax revenue and borrowing are two main ways the government can fill deficits.
When the government is operating on a deficit or deficit spending, it usually elects to borrow money from the loanable
funds market. When the government borrows money, it is in fact increasing the demand for money in the economy. A
byproduct of this increase in demand for money is higher interest rates. When the government has to borrow money, it
“crowds out,” or takes money away from, the private sector. This forces the private sector to compete for a lesser share
of funds.
The other option the government has is taxation. Tax cuts are made when the economy is in a contraction, and tax increases
are made when the economy is in a healthy state of expansion.
Contractionary Fiscal Policy
When demand-pull inflation occurs, the government implements contractionary fiscal policy, which means restrictive
spending and/or increased taxes. These tools are used to offset the increasing demand in the economy. Sometimes too
much demand is not good for the economy; it erodes purchasing power and creates a rise in the price level. The govern-
ment attempts to strengthen purchasing power by limiting the ability of consumers to spend. Although this concept may
sound confusing, when the government makes it more difficult for consumers to demand products, the price level and
the value of the dollar stabilize.
Figure 5-2 illustrates what happens to aggregate demand when the government chooses to implement contractionary
fiscal policy. Aggregate demand decreases and the price level is stabilized as a result of the government’s restrictive
spending and/or increased tax rate.
Price
Level AD(^1) AD 2
Real GDP