- Consumer confidence rises as the economy grows, causing them to spend more and take on more debt. As a result, demand continues to rise, resulting in increasing prices.
- Increasing export demand: A sudden increase in exports drives the currencies involved to undervalue.
- Expected inflation: Companies may raise their prices in anticipation of rising inflation in the near future.
- More money in the system: When the money supply expands but there aren’t enough products to go around, prices rise.
Is it true that government expenditure raises inflation?
- The US government produced and spent trillions of dollars to stimulate the economy, resulting in unprecedented inflation.
- Too many dollars are chasing a static supply of products, and the economy is collapsing.
Inflation is a difficult concept to grasp. On a personal level, it causes harm to consumers through no fault of their own. It gives customers poor options, such as spending more money for the same things, changing your consumption basket, or foregoing a purchase. It depletes workers’ salaries and valuable savings. In politics, inflation has damaged candidates, demonstrating that voters are concerned about it. By a 77 to 20 majority, voters in North Carolina rated inflation as a more serious issue than unemployment.
So, what is inflation, exactly? Simply explained, inflation is defined as a general increase in prices and a decrease in the value of money. “Inflation is always and everywhere a monetary phenomenon,” said economist Milton Friedman. It is not a budgetary phenomenon, as it has nothing to do with taxes or government budgets. Inflation, Friedman concluded, “can only be caused by a faster growth in the supply of money than in productivity.”
The current bout of inflation is the result of huge spending: the government spent the equivalent of 27 percent of GDP on “Covid relief” and “stimulus” in 2020 and 2021, the second-largest fiscal reaction as a percentage of GDP of any industrialized country. And the Federal Reserve’s newly produced money was mostly used to fund this spending.
The money supply graph below depicts the tremendous infusion of cash since the outbreak of the pandemic:
The money supply expanded by the same amount in just 21 months, from February 2020 to November 2021, as it did in the roughly 10-year period before it, from July 2011 to February 2020.
Due to the uncertainties surrounding the outbreak of the pandemic, consumers spent less money. Personal consumption, on the other hand, had surpassed pre-pandemic levels by March 2021, continuing long-term trends.
High, simulated demand is being supported by trillions of newly produced currency. Supply is unable to keep up with demand.
The government-mandated corporate shutdown is exacerbating the supply problem. Shutdowns have wreaked havoc on entire industries and caused a drop in the labor force participation rate. The government also raised benefits to those unemployed people who refused to work, prompting some wages to rise even more as businesses competed for workers with a government check in particular industries. Wage gains, on the whole, haven’t kept up with inflation.
While government programs helped some people in need (for example, businesses with Paycheck Protection Program loans), much of the “relief” money was wasted. According to The Heritage Foundation, public health was addressed in less than 10% of the $1.9 trillion “American Rescue Plan” Act for Covid relief.
Consumer and producer prices are now at all-time highs. Wholesale costs have grown 9.7% since last year, according to the most recent data. Consumer prices have increased by 7% in the last year, reaching a 39-year high. CPI hikes of at least 0.5 percent have occurred in six of the last nine months. A growing cost of living is eating away at the value of your dollars.
Government spending in the trillions has resulted in an economy bloated with cheap money. Solutions to inflation are neither quick nor simple due to the significant spending and myriad downstream repercussions of the pandemic’s reactions. The Federal Reserve indicated recently that it expects to raise interest rates three times in 2022 to keep inflation under control. However, with an economy buoyed up and hooked to cheap money, doing so could have a significant negative impact on the economy as a whole. Furthermore, with increased interest rates, servicing the large national debt would become much more expensive.
Unfortunately, White House leaders have provided dubious answers, frequently blaming an undeserving third party. The Biden Administration maintained throughout the end of last year that the “Build Back Better” Act would assist to reduce inflation by making living less expensive for working people at no cost. It was unclear how spending trillions more in freshly minted currency would truly combat inflation.
Another ridiculous approach proposed by the White House is to use antitrust to disarm the large corporations (who were large long before current inflation) that are allegedly responsible for price increases. The Biden administration even blames inflation on port delays and the supply chain crisis. While these supply chain concerns exacerbate an already strained supply, they are not the cause of inflation, which is defined as a general increase in prices rather than a rise in prices in specific industries. These measures are more about furthering Biden’s goal than they are about lowering inflation.
While politicians debate remedies, inflation continues to wreak havoc on American families. Low-wage workers, pensioners, and people on fixed incomes are the ones that suffer the most because they are unable to keep up with inflationary pressures. Inflation has the impact of a hidden tax on them, which they bear the brunt of. Because the majority of their income is already spent on needs, they have limited room to adjust their consumption habits.
America requires leaders who see the true dangers of inflation. Inflation is a small annoyance for the wealthy, but it poses a severe threat to the budgets of the working class and low-income people. Creating inflation indiscriminately to get pet projects through Congress snubs those who are most in need.
Is inflation caused by increasing spending?
- Inflation is the rate at which the price of goods and services in a given economy rises.
- Inflation occurs when prices rise as manufacturing expenses, such as raw materials and wages, rise.
- Inflation can result from an increase in demand for products and services, as people are ready to pay more for them.
- Some businesses benefit from inflation if they are able to charge higher prices for their products as a result of increased demand.
What happens if the government spends more?
Government expenditure can be a valuable instrument for governments in terms of economic policy. The use of government spending and/or taxation as a method to influence an economy is known as fiscal policy. Expansionary fiscal policy and contractionary fiscal policy are the two types of fiscal policy. Expansionary fiscal policy is defined as an increase in government expenditure or a reduction in taxation, whereas contractionary fiscal policy is defined as a reduction in government spending or an increase in taxes. Governments can utilize expansionary fiscal policy to stimulate the economy during a downturn. Increases in government spending, for example, immediately enhance demand for products and services, which can assist boost output and employment. Governments, on the other hand, can utilize contractionary fiscal policy to calm down the economy during a boom. Reduced government spending can assist to keep inflation under control. In the short run, during economic downturns, government spending can be adjusted either by automatic stabilization or discretionary stabilization. Automatic stabilization occurs when current policies adjust government spending or taxation in response to economic shifts without the need for new legislation. Unemployment insurance, which offers cash help to unemployed people, is a prime example of an automatic stabilizer. When a government responds to changes in the economy by changing government spending or taxes, this is known as discretionary stabilization. For example, as a result of the recession, a government may opt to raise government spending. To make changes to federal expenditure under discretionary stabilization, the government must adopt a new law.
One of the earliest economists to call for government deficit spending as part of a fiscal policy response to a recession was John Maynard Keynes. Increased government spending, according to Keynesian economics, improves aggregate demand and consumption, resulting in increased production and a faster recovery from recessions. Classical economists, on the other hand, think that greater government expenditure exacerbates an economic downturn by diverting resources from the productive private sector to the unproductive public sector.
Crowding out is the term used in economics to describe the possible “moving” of resources from the private to the public sector as a result of increased government deficit expenditure. The market for capital, also known as the market for loanable funds, is depicted in the diagram to the right. The downward sloping demand curve D1 indicates company and investor demand for private capital, whereas the upward sloping supply curve S1 represents private individual savings. Point A represents the initial equilibrium in this market, where the equilibrium capital quantity is K1 and the equilibrium interest rate is R1. If the government spends more than it saves, it will have to borrow money from the private capital market, reducing the supply of savings to S2. The new equilibrium is at point B, where the interest rate has risen to R2 and the amount of private capital accessible has reduced to K2. The government has effectively raised borrowing costs and removed savings from the market, effectively “crowding out” some private investment. Private investment could be stifled, limiting the economic growth spurred by the initial surge in government spending.
Why would expenditure by the government raise inflation?
According to the new idea, inflation occurs when the total amount of government debt exceeds what individuals expect the government to repay. The cost of everything rises, but the value of the dollar falls.
What impact does the government have on inflation?
Some countries have had such high inflation rates that their currency has lost its value. Imagine going to the store with boxes full of cash and being unable to purchase anything because prices have skyrocketed! The economy tends to break down with such high inflation rates.
The Federal Reserve was formed, like other central banks, to promote economic success and social welfare. The Federal Reserve was given the responsibility of maintaining price stability by Congress, which means keeping prices from rising or dropping too quickly. The Federal Reserve considers a rate of inflation of 2% per year to be the appropriate level of inflation, as measured by a specific price index called the price index for personal consumption expenditures.
The Federal Reserve tries to keep inflation under control by manipulating interest rates. When inflation becomes too high, the Federal Reserve hikes interest rates to slow the economy and reduce inflation. When inflation is too low, the Federal Reserve reduces interest rates in order to stimulate the economy and raise inflation.
What role does government spending have in lowering inflation?
Fed Funds Rate (FFR) When banks raise interest rates, fewer people want to borrow money since it is more expensive to do so while the money is accruing at a higher rate of interest. As a result, spending falls, prices fall, and inflation slows.
What are the five factors that contribute to inflation?
Inflation is a significant factor in the economy that affects everyone’s finances. Here’s an in-depth look at the five primary reasons of this economic phenomenon so you can comprehend it better.
Growing Economy
Unemployment falls and salaries normally rise in a developing or expanding economy. As a result, more people have more money in their pockets, which they are ready to spend on both luxuries and necessities. This increased demand allows suppliers to raise prices, which leads to more jobs, which leads to more money in circulation, and so on.
In this setting, inflation is viewed as beneficial. The Federal Reserve does, in fact, favor inflation since it is a sign of a healthy economy. The Fed, on the other hand, wants only a small amount of inflation, aiming for a core inflation rate of 2% annually. Many economists concur, estimating yearly inflation to be between 2% and 3%, as measured by the consumer price index. They consider this a good increase as long as it does not significantly surpass the economy’s growth as measured by GDP (GDP).
Demand-pull inflation is defined as a rise in consumer expenditure and demand as a result of an expanding economy.
Expansion of the Money Supply
Demand-pull inflation can also be fueled by a larger money supply. This occurs when the Fed issues money at a faster rate than the economy’s growth rate. Demand rises as more money circulates, and prices rise in response.
Another way to look at it is as follows: Consider a web-based auction. The bigger the number of bids (or the amount of money invested in an object), the higher the price. Remember that money is worth whatever we consider important enough to swap it for.
Government Regulation
The government has the power to enact new regulations or tariffs that make it more expensive for businesses to manufacture or import goods. They pass on the additional costs to customers in the form of higher prices. Cost-push inflation arises as a result of this.
Managing the National Debt
When the national debt becomes unmanageable, the government has two options. One option is to increase taxes in order to make debt payments. If corporation taxes are raised, companies will most likely pass the cost on to consumers in the form of increased pricing. This is a different type of cost-push inflation situation.
The government’s second alternative is to print more money, of course. As previously stated, this can lead to demand-pull inflation. As a result, if the government applies both techniques to address the national debt, demand-pull and cost-push inflation may be affected.
Exchange Rate Changes
When the US dollar’s value falls in relation to other currencies, it loses purchasing power. In other words, imported goods which account for the vast bulk of consumer goods purchased in the United States become more expensive to purchase. Their price rises. The resulting inflation is known as cost-push inflation.
What are the three most common reasons for inflation?
Demand-pull inflation, cost-push inflation, and built-in inflation are the three basic sources of inflation. Demand-pull inflation occurs when there are insufficient items or services to meet demand, leading prices to rise.
On the other side, cost-push inflation happens when the cost of producing goods and services rises, causing businesses to raise their prices.
Finally, workers want greater pay to keep up with increased living costs, which leads to built-in inflation, often known as a “wage-price spiral.” As a result, businesses raise their prices to cover rising wage expenses, resulting in a self-reinforcing cycle of wage and price increases.
Why is it harmful to increase government spending?
First, it raises the cost of living through inflating through subsidies. Subsidies from the government artificially boost demand. As a result, prices have risen, affecting the working poor and middle class disproportionately. Companies that sell subsidized products become wealthier, while increasing prices create demand for larger subsidies. The cycle continues, and costs continue to rise.
Subsidies are to blame for the 497 percent increase in the average cost of attending a four-year college or university between 1986 and 2018, more than twice the rate of inflation. Universities respond to increases in state and federal subsidies by decreasing their own aid, boosting tuition or fees, or doing all of the above, according to a large body of research. As a result, many middle-class children and families are forced to borrow money to pay for school.
What effect does government spending have on the economy?
The federal government has raised government expenditure significantly to stimulate economic growth in reaction to the financial crisis and its impact on the economy. Policymakers should assess whether federal expenditure genuinely encourages economic growth, given the billions of dollars allocated to this purpose. Although the findings are not all consistent, historical evidence implies that government expenditure has an unfavorable long-term effect: it crowds out private-sector spending and wastes money.
Policymakers should examine the best literature available to determine the likelihood of attaining the desired effect from government spending intended to stimulate growth. When assumptions or data are unknown, the analysis should thoroughly investigate the potential repercussions of various assumptions or potential values for the uncertain data.
TRADITIONAL GROWTH RATIONALES
Government spending proponents argue that it offers public goods that markets do not, such as military defense, contract enforcement, and police services. 1 Individuals have little incentive to provide these types of goods, according to standard economic theory, because others frequently utilize them without paying.
One of the most influential economists of the twentieth century, John Maynard Keynes, advocated for government spending, even if it meant running a deficit to do it.
2 He proposed that when the economy is in a slump and labor and capital unemployment is high, governments can spend money to generate jobs and put jobless or underutilized capital to work. One of the implied rationales for the current federal stimulus expenditure is that it is essential to improve economic production and foster growth, according to Keynes’ theory. 3
These spending theories presume that the government knows which commodities and services are underutilized, which public goods will bring value, and where resources should be redirected. There is, however, no data source that allows the government to determine where commodities and services may be used most productively. 4 When the government is unable to precisely target the initiatives that would be most productive, it is less likely to stimulate growth.
POLITICS DRIVES GOVERNMENT SPENDING
Aside from the communication problem, the political process itself has the potential to stifle economic growth. Professor Emeritus of Law Gordon Tullock of George Mason University, for example, believes that politicians and bureaucrats attempt to control as much of the economy as possible. 5 Furthermore, the private sector’s desire for government resources leads to resource misallocation through “rent seeking,” the process by which businesses and individuals lobby the government for money. Legislators distribute money to favored organizations rather than spending it where it is most needed. 6 Though incumbents seeking reelection may benefit politically from this, it is not conducive to economic progress.
The evidence backs up the notion. Political efforts to maximize votes accounted between 59 and 80 percent of the variance in per capita federal funding to the states during the Great Depression, according to a 1974 report by Stanford’s Gavin Wright. 7 Finally, under the Democratic Congress and President, money was concentrated in Western states, where elections were considerably closer than in the Democratically held South. According to Wright’s view, instead of allocating expenditure solely on the basis of economic need during a crisis, the ruling party may disperse funds based on the likelihood of political gains.
THE CONSEQUENCES OF UNPRODUCTIVE SPENDING AND THE MULTIPLIER EFFECT
The fiscal multiplier is frequently cited by proponents of government expenditure as a means for spending to stimulate growth. The multiplier is a factor that determines how much a particular amount of government spending improves some measure of overall output (such as GDP). The multiplier idea states that an initial burst of government expenditure trickles through the economy and is re-spent again and over, resulting in the economy increasing. A multiplier of 1.0 means that if the government developed a project that employed 100 people, it would employ precisely 100 individuals (100 x 1.0). A multiplier greater than one indicates increased employment, whereas a value less than one indicates a net job loss.
For most quarters, the incoming Obama administration utilized a multiplier estimate of about 1.5 for government expenditure in its 2009 assessment of the stimulus plan’s job benefits. This means that for every dollar spent on government stimulus, GDP rises by one and a half dollars. 8 Unproductive government spending, on the other hand, is likely to have a lesser multiplier effect in practice. Harvard economists Robert Barro and Charles Redlick estimated in a September 2009 report for the National Bureau of Economic Research (NBER) that the multiplier from government defense spending hits 1.0 at high unemployment rates but is less than 1.0 at lower unemployment rates. The multiplier effect of non-defense spending could be considerably smaller. 9
Another recent study backs up this conclusion. Barro and Ramey’s multiplier values, which are significantly lower than the Obama administration’s predictions, suggest that government spending may actually slow economic growth, potentially due to inefficient money management.
CROWDING OUT PRIVATE SPENDING AND EMPIRICAL EVIDENCE
Government expenditure is financed by taxes; thus, a rise in government spending raises the tax burden on taxpayers (now or in the future), resulting in a reduction in private spending and investment. “Crowding out” is the term for this effect.
Government spending may crowd out interest-sensitive investment in addition to crowding out private spending.
11 Government spending depletes the economy’s savings, raising interest rates. This could lead to decreased investment in areas like home construction and productive capacity, which comprises the facilities and infrastructure that help the economy produce goods and services.
According to a research published by the National Bureau of Economic Research (NBER), government spending shows a high negative connection with company investment in a panel of OECD nations.
12 Government spending cuts, on the other hand, result in a spike in private investment. Robert Barro reviews some of the most influential research on the subject, all of which find a negative relationship between government spending and GDP growth. 13 Furthermore, Dennis C. Mueller of the University of Vienna and Thomas Stratmann of George Mason University showed a statistically significant negative link between government size and economic growth in a study of 76 countries. 14
Despite the fact that the majority of the research shows no link between government spending and economic growth, some empirical studies do. For example, economists William Easterly and Sergio Rebelo discovered a positive association between general government investment and GDP growth in a 1993 research that looked at empirical data from about 100 nations from 1970 to 1988. 15
The empirical findings’ lack of agreement highlights the inherent difficulty in evaluating such connections in a complex economy. Despite the lack of empirical agreement, the theoretical literature suggests that government spending is unlikely to be as effective as just leaving money in the private sector in terms of economic growth.
WHY DOES IT MATTER RIGHT NOW?
The American Recovery and Reinvestment Act of 2009, which allowed $787 billion in spending to stimulate job growth and boost economic activity, was passed by Congress in 2009. 16 The budgetary implications of this act, as well as other government spending efforts targeted at improving the federal budget’s economic outlook, can be observed in recent federal outlays. Total federal spending has risen gradually over time, as seen in Figure 1, with a substantial increase after 2007. Figure 2 shows that total federal spending as a percentage of GDP has increased dramatically in the last two years, reaching about 30%. As previously stated, this spending may have unintended consequences that stifle economic growth by crowding out private investment.
CONCLUSION
Even in a time of crisis, government expenditure is not a surefire way to boost an economy’s growth. A growing body of research suggests that government spending intended to promote the economy may fall short of its purpose in practice. As the US embarks on a large government spending initiative, such discoveries have serious implications. Before approving any additional expenditure to increase growth, the government should determine whether such spending is likely to stimulate growth using the best peer-reviewed literature and indicate how much uncertainty surrounds those projections. Prior to passing this type of law, these studies should be made available to the public for comment.
ENDNOTES
1. Richard E. Wagner, Fiscal Sociology and the Theory of Public Finance: An Explanatory Essay, Edward Elgar Publishing Ltd., Cheltenham, 2007, p. 28.
2. John Maynard Keynes is a British economist.