Economics and the 2008 crisis: a Keynesian view
Economics and the 2008 crisis: a Keynesian view

Start this free course now. Just create an account and sign in. Enrol and complete the course for a free statement of participation or digital badge if available.

6.3 Government expenditure (3)

To model the impact of government expenditure, the first step is to introduce a new term G to represent planned government spending. Whereas earlier it was assumed that the economy consisted only of private agents (households and firms), the government sector (also called the public sector) is now included in the model. Like private investment, government spending is treated in this model as exogenous.

It is important to note that the portion of government spending that takes the form of transfer payments is not included in G since it adds nothing directly to the demand for goods and services. However, as you will see, transfer payments do affect the household consumption component of aggregate demand and income.

Aggregate demand (AD) in the extended model consists of planned consumption (C ) and planned investment (I ), as before, with an additional term (G ) representing planned government spending:

AD = C + I + G

Some elements of spending may form part of I at one time in history and part of G at another. For example, investment in railways in the 1920s would be categorised as part of private investment (I ), whereas after railway nationalisation in the 1940s such investment would be categorised as part of government spending (G ). Keynes made the point that expenditure by the government on roads was equivalent to private investment in the railways. In fact, since in times of stagnation, the private sector might be reluctant to invest, government spending can be required to fill the gap – not just to boost aggregate demand, but also to provide vitally needed infrastructure investment.

This new role for government spending can now be shown in the aggregate demand diagram (Figure 14). In this diagram, government spending (G ) and investment (I ) are shown as exogenous elements of aggregate demand, unaffected by changes in income. The combined total of government spending and private investment (I + G ) is represented by a horizontal line. Also exogenous is the intercept of the consumption function (a). You may recall from earlier sections that the slope of the consumption function is represented by the coefficient b.

Described image
Figure 14 Government spending and aggregate demand

To derive the new aggregate demand schedule, the horizontal line for combined investment and government spending can be added to the consumption function. The new aggregate demand schedule AD = C + I + G has an intercept a + I + G and the same slope (b) as the consumption function.

Take your learning further

Making the decision to study can be a big step, which is why you'll want a trusted University. The Open University has 50 years’ experience delivering flexible learning and 170,000 students are studying with us right now. Take a look at all Open University courses.

If you are new to University-level study, we offer two introductory routes to our qualifications. You could either choose to start with an Access module, or a module which allows you to count your previous learning towards an Open University qualification. Read our guide on Where to take your learning next for more information.

Not ready for formal University study? Then browse over 1000 free courses on OpenLearn and sign up to our newsletter to hear about new free courses as they are released.

Every year, thousands of students decide to study with The Open University. With over 120 qualifications, we’ve got the right course for you.

Request an Open University prospectus371