Free Economics Essays
Government Spending on Infrastructure and Inflation
Discuss whether increased government spending on a country’s infrastructure will always lead to a rise in the rate of inflation. Use aggregate demand and aggregate supply analysis to support your answer. [12]
Category:
Macroeconomic Factors and Policies
[CIE AS level November 2018]
Answer
Tip : Write about how the increased spending on a country’s infrastructure would affect aggregate demand and aggregate supply. The shift aggregate supply to the right could be sufficient to offset the increase in aggregate demand and prevent a rise in the rate of inflation.
Step ➊ : Define ‘inflation’ in the introduction
Since government spending is considered as a component of aggregate demand, an increase in spending on infrastructure will lead to an increase in aggregate demand and this will generally result in inflation. Inflation is defined as a sustained increase in an economy’s price level. However, there are certain circumstances where this is not the case. This can be explained by using aggregate demand and aggregate supply analysis.
Step ➋ : Discuss whether an increase in government spending can lead to inflation due to a rise in aggregate demand.
➤ 2.1 The following diagram shows how an increase in government spending in a country's infrastructure can result in a rise in inflation.
Aggregate demand (AD) consists of four components: Consumption (C), Investment (I), Government spending (G) and Net exports (X–M). Investment is a component of aggregate demand. An increase in government spending on infrastructure will shift the AD curve outwards, from AD to AD1. As a result, the price level rises from P to P1. In this case, a rise in government spending on infrastructure causes demand-pull inflation. This occurs when prices are pulled up by increases in aggregate demand that are not matched by equivalent increases in aggregate supply.
➤ 2.3 The effect of inflation will depend on how steep the Aggregate Supply curve is, as in how close it is to full employment. This is shown in the diagram below.
Keynesians often represent the LRAS curve as perfectly elastic at low rates of output, then upward sloping over a range of output and finally perfectly inelastic. This is to emphasise their view that, in the long run, an economy can operate at any level of output and not necessarily at full capacity.
The figure above shows that when aggregate demand shifts from AD0 to AD1, output can be raised from Y0 toY1 without increasing the price level. This is because when output and hence employment are low, firms can attract more resources without raising their prices. There is time for input prices to change but, due to the low level of aggregate demand, they do not. For example, when unemployment is high, the offer of a job may be sufficient to attract new workers.
When the aggregate demand curve shifts from AD1 to AD2, firms begin to experience shortages of inputs and bid up wages, raw material prices and the price of capital equipment. The price level thus rises from P1 to P2.
As output reaches Y2, the economy is producing the maximum output it can make with existing resources. When aggregate demand shifts from AD2 to AD3 , there is a price rise from P2 to P3, inflation becomes a problem. Additional increases in demand lead to higher prices than output.
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Step ➌ : Discuss the impact government spending on aggregate supply and it’s effect on inflation.
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➤ 3.1 It can also be argued that the improved infrastructure should also increase aggregate supply to offset the increase in aggregate demand. This can be shown in the diagram below.
First, an increase in government spending on infrastructure shifts the aggregate demand curve to the right from AD to AD1, the price level rises from P to P1. However, the increase in spending may also result in a reduction in costs for firms. For example, if the government increases it's spending to build new high-speed motorways, this will enable firms all over the country to transport their merchandise faster and this will reduce their transport costs. These firms will be willing to increase their supply and thus the aggregate supply will shift downwards from AS to AS1. The price will fall back from P1 to P. In this case, inflation will not occur. It should nevertheless be noted that it may take a long time for firms to adapt and use the new infrastructure and thus the price level may take time to fall back.
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Step ➍ : Conclude whether increased government spending on a country’s infrastructure will always lead to a rise in the rate of inflation.
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To conclude, an increase in government spending on infrastructure will not always cause inflation. The effect of inflation will depend on how steep the Aggregate Supply curve is, as in how close it is to full employment. It will also depend on whether the improved infrastructure will increase aggregate supply to offset the increase in aggregate demand.
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♕ Mark scheme
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For analysis of the impact of increased government spending upon aggregate demand with reference to the intersection of the increased aggregate demand with the aggregate supply curve. (Up to 4 marks)
For analysis of the impact of increased government spending upon infrastructure and aggregate supply with reference to the intersection of the increased aggregate supply with the aggregate demand the curve. (Up to 4 marks)
(AN: up to 8 marks)
For evaluative comment with due reference to the relative shifts of each curve and their point of intersection (Up to 3 marks) to arrive at a conclusion on whether the increased spending will always cause a rise in the rate of inflation (1 mark). (EV: up to 4 marks)
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♕ Examiner’s report
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Although many candidates were able to provide analysis to explain how an increase in government spending would increase aggregate demand and potentially cause inflation, a disappointingly large number of candidates failed to see how the increased spending on a country’s infrastructure would affect aggregate supply. The effect would be to shift aggregate supply to the right and this could be sufficient to offset the increase in aggregate demand and prevent a rise in the rate of inflation. Inevitably, this omission resulted in analysis that was incomplete and this undermined the candidate’s ability to provide evaluative comment and reach a reasoned conclusion. Marks were generally disappointing here.
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