How does increasing government spending affect aggregate demand in the economy?



I’ve looked online but I can’t seem to find a clear answer. Thanks

In: Economics

The general idea is that aggregate demand is comprised of _all_ of the entities buying goods. That includes individual consumers, businesses, foreign firms and governments. If any of those groups starts buying more, then aggregate (i.e. total) demand goes up, so increasing in spending from any of them can increase aggregate demand.

The US Government is somewhat special in this regard, though, as it basically has access to unlimited funds over the short term. If the economy is flagging due to low demand, it can take on debt with incredible ease and spend that money in the economy buying goods and services. The firms that sell goods to the government then take that money and buy goods and services of their own, so every $1 spend by the government could have a 3-6x effect on demand. Then, once the economy is good again, spending can be reduced, taxes increased and the debt paid back.

Of course, that is a very Keynesian opinion. Ask a Chicago-school economist and they will tell you that government spending has zero effect on aggregate demand…

If the government increases spending, then they are creating more aggregate demand for goods and services that they consume… if they buy new Tahoes for National Park rangers, and missiles, and upgrade computers at the Dept. of Agriculture those all create demand for those goods. Additionally, the companies supplying those goods, selling those goods, pay their workers who then have money to spend on whatever it is that they need/want. They factory worker building missiles picks up overtime shifts to pay for his family’d Disney vacation. The Wyoming Chevy dealer that sold 10 trucks for use in Yellowstone buys a new pair of cowboy boots. The sales rep at Dell decides to move to a nicer apartment.

It doesn’t, at least not as you have worded it. To clarify, government *deficit* spending can increase aggregate demand. That’s because while non-deficit government spending simply replaces the spending it removes from the private sector, deficit spending increases the total amount of money being spent *today* by borrowing it from the future.

Think of it like this:

You’re five. You earn $10 with a lemonade stand. If you spend that $10 that’s $10 worth of demand. If your dad “taxes” you $3 and you have $7 left, and you each spend that, you end up with the same $10 worth of demand. If your dad increases his spending without a deficit, he must take more of your money. Say he takes $4, leaving you $6. Together you still have $10 between you.

*But* if you spend your $7 and your dad spends $4 instead of the $3 you gave him, then the total demand is $11, which is more. To do that, your dad had to “borrow” $1 from future you, which may hurt aggregate demand in the future (repaying debt is demand neutral).

A caveat. If you intend to somehow remove your money from productive use – say to bury it in a hole somewhere, then you might be able to make a case that government spending will increase demand because you’re taking your money out of the game, so to speak. This doesn’t go for most forms of savings – banks, stocks, etc – where the money is still used for productive means (investment, loans).