Government expenditure refers to the spending on goods and services by the government. Examples are purchasing goods for operations and investing in public goods. Also, some expenses do not involve the exchange of goods and services, i.e., transfer payments.
If spending exceeds revenue, the government runs a fiscal deficit. Conversely, if revenue exceeds expenditure, the government runs a fiscal surplus. And, when expenditure equals revenue, we call it balanced fiscal.
Types of government expenditure
Government spending consists of three main categories, namely:
- Transfer payments involve monetary payments to the private sector. Examples are unemployment benefits, capital transfers, and job search benefits. In the expenditure approach, GDP excludes this component. Transfer payments do not involve exchanging goods and services, even if the government hands over the money.
- Current expenditures cover routine expenditure for operations.
- Capital expenditures include spending on infrastructure, such as roads. These expenditures are vital to increasing the capital stock in the economy.
The effect of government spending on the economy
Spending contributes to increasing potential GDP. Investment in infrastructure creates a multiplier effect on the economy. Such investment also increases the productive capacity of the economy in the long run.
By changing its expenditure, the government can influence economic activity. Such policies can minimize the adverse effects of the economic cycle.
To prevent a recession, the government increases its spending. Increased spending stimulates higher aggregate demand. That ultimately stimulates the production and drives real GDP. When production expands, it helps to reduce the unemployment rate.
Some spending also provides monetary income for households such as unemployment benefits. Such programs help the unemployed to maintain a minimum standard of living to reduce extreme poverty.
As a fiscal tool
Spending is a fiscal tool other than taxes. The government can use it to influence economic activity.
If governments adopt expansionary policies, they will increase spending. Conversely, in contractionary policies, the government will reduce spending.
The economic expansion policy is to revive economic growth, usually during a recession. Higher spending leads to increased demand for goods and services in the economy.
Higher demand stimulates businesses to increase their production. They also began to recruit new workers. As a result, the economy is growing, and the unemployment rate is declining.
A growing economy leads to better prospects for household income. Because they have more money, they should spend more on goods and services. Once again, encourage businesses to increase production. This process continues, and hence government spending has a multiplier effect on the economy.
Meanwhile, the government implements a contractionary policy to avoid an overheating economy. The government reduces spending to reduce aggregate demand and moderate inflation.
Fiscal deficit and the crowding-out effect
Fiscal deficits do not always result in higher economic growth. It depends on how much influence government spending has on the gross domestic product (GDP).
Let’s recall the following equation:
GDP = C + I + G + NX
- C: household consumption
- I: gross business investment
- G: government expenditure
- NX: net exports
So, government spending is not the only contributor to GDP. There are three other contributors.
Well, I will discuss the effects of government spending on gross investment by the private sector.
When experiencing a fiscal deficit, the government will borrow to cover the shortfall. For this reason, they will owe, for example, by issuing bonds.
The government may offer high-interest rates to attract investors. This situation ultimately raised interest rates in the economy. As a result, borrowing costs become more expensive.
The private sector can respond to higher borrowing costs by delaying investment. As a result, private investment fell. The situation where increasing government deficits reduce private investment is called the crowding-out effect.
The net effect on the economy depends on which one is more significantly influential on aggregate demand? Is it government spending or private investment? Sometimes, the decline in private investment is far more significant than the increase in government spending.
Transfer payments – such as unemployment benefits – act as an automatic stabilizer. These expenditures change counter-cyclically. When the business cycle goes up, it decreases and when the cycle goes down, it goes up.
Payments declined during the economic boom. In this situation, unemployment decreases in line with increased production.
Conversely, payments increase when recession. In this period, economic activities shrank. The unemployment rate goes up because businesses cut production and reduce labor.