Part 1: Introduction
The rate at which the general level of prices for commodities and services increases along with the decrease in the purchasing power of currency is termed as inflation. The rate of inflation is mainly restricted by the Central banks in order to avoid deflation. Inflation is mainly defined as a sustained rise in the general level of prices for commodities as well as services. It can also be measured as a yearly percentage increase. When inflation takes place, the value of dollar does not stay steady. Government spending or government expenditure on the other hand comprises of all the government consumption as well as investment. The attainment of goods and services by the government leads to future benefits (Bresciani-Turroni 2013).
According to the Keynesian view, the government requires to spend in order to accomplish stability in the financial system as well as to stimulate output and investment. According to the Neo-Classical economists, the increase in the expenditure of the government in the form of intervention will result to high rate of inflation given the full-employment assumption. In most of the countries fiscal policies are faced with various problems that are related to complexities in tax collection, institutional insufficiency as well as problems related to foreign capita that in turn leads to inflation. As a result, government expenditures in addition to the collision on manufacture can have an impact on inflation (Godin 2014).
Part 2: Analysis
Inflation is the most deceitful and premeditated policy of the government when it does not wish to reduce the expenditure. In order to cover what is expends in surplus of its income the government creates new money. When the government starts printing new money it leads to increase in money supply. This in turn leads to increase in money supply and as a result, money supply rises faster as compared to real output. If money supply is increased by 4 percent, the aggregate demand also increases by 4 percent. The increase in money supply helps to get unemployed resources used in the general economy. When more it expended than is raised by taxes, the government with fiat money makes up the difference. The unwillingness of the government to reduce its expenditure mainly leads to increase in inflation. The individuals do not have to pay supplementary taxes when government prints more money. Through monetary degradation, the government acquires wealth from the individuals and spends it. According to the Keynesian view, the government also spends to ensure constancy of the economy that will motivate productivity through direct public spending as well as investment (Olivera 2014).
Figure 1: Increase in government spending leads to increase in aggregate demand
(Source: Created by Author)
The graph shows that an increase in government spending leads to increase in aggregate demand. As a result, the aggregate demand increases from AD to AD1 towards the right. This in turn will lead to increase in income and a fall in unemployment. The increase in aggregate demand leads to demand-pull inflation. This in turn leads to increased pressure on scarce resources. Inflation starts with government expansion of the money supply that instantly generates benefits for some individuals. Government spending mainly takes place when the government tries to reallocate income between the rich and the poor. Various hypothetical and empirical researches mainly focus on the relationship between inflation and government spending (Mian and Sufi 2012).
It has been found that there is a positive relation between inflation and the size of government. Inflation is mainly considered as a social evil as it diminishes the costs of the public sector. With the increase in government expenditure, the budget situation of the economy deteriorates. However, the real value of government spending decreases with the increase in inflation. The increase in government spending will lead to increase in budget deficit. Government expenditure is also inflationary in nature and as a result, a 10 percent increase in government expenditure leads to 1 percent increase in prices (Oto Peral?as and Romero ?vila 2013).
Figure 2: Increase in Aggregate Demand
(Source: Created by Author)
The graph shows that expansionary fiscal policy leads to diminishing of unemployment. As a result, government spending is increased that will shift the AD curve to the right and leading to increasing real GDP. Although, government spending leads to increasing GDP in the economy it also leads to increase in inflation (Hannsgen 2014).
Part 3: Conclusion
It can be concluded that inflation mainly misrepresents the calculation in the economy that leads to error in trade. The increase in the expenditure of the government in the form of intervention will result to high rate of inflation given the full-employment assumption. The expansion of money supply by the government leads to inflation. It has also been concluded that the unwillingness of the government to reduce its expenditure mainly leads to increase in inflation. The reallocation of income between the rich and the poor also leads to Government spending. The increase in government spending leads to inflation that disfigures prices and leads to changes in the pattern of production. It has been concluded that government expenditures in addition to the collision on manufacture can have an impact on inflation. However, though the increase in government expenditure leads to higher GDP however; it will also lead to increase in budget deficit. The arbitrary reserve requirements on banks are the only way that will restrict the supply of money. If the government expenditure is reduced, it will lead to reduction in inflation.
Bresciani-Turroni, C., 2013. The Economics of Inflation: A study of currency depreciation in post-war Germany, 1914-1923. Routledge.
Godin, A., 2014. Marc Lavoie, Post-Keynesian Economics: New Foundations. Chapter 5. Effective Demand and Employment. Revue de la r?gulation. Capitalisme, institutions, pouvoirs, (16).
Hannsgen, G., 2014. Fiscal Policy, Chartal Money, Mark?€ђup Dynamics and Unemployment Insurance in a Model of Growth and Distribution.Metroeconomica, 65(3), pp.487-523.
Mian, A.R. and Sufi, A., 2012. What explains high unemployment? The aggregate demand channel (No. w17830). National Bureau of Economic Research.
Olivera, J.H., 2014. Money, prices and fiscal lags: a note on the dynamics of inflation. PSL Quarterly Review, 20(82).
Oto?€ђPeral?as, D. and Romero?€ђ?vila, D., 2013. Tracing the link between government size and growth: the role of public sector quality. Kyklos, 66(2), pp.229-255.