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.

Figure 14 Government spending and aggregate demand

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This diagram has Aggregate Demand (AD) on the vertical axis and Income (Y) on the horizontal axis.

A solid line at a 45 degree angle is drawn upwards from the origin.

From a short way up the vertical axis, a horizontal line is drawn. This is labelled I+G.

A little above this horizontal line, from point ‘a’ on the vertical axis, a straight line is drawn upwards, with a shallower slope than the 45 degree line. This is labelled ‘Consumption function, C=a+bY.’

Somewhat above the consumption function, and parallel to it, is a line drawn from a point on the vertical axis a+I+G. This line is labelled ‘Aggregate Demand schedule, AD=C+I+G.’

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.