Long term economic growth can also be affected by an increased amount of government spending. Changes in aggregate supply can lead to increases in the potential output of the economy. If the increased level of potential output is matched with increases in AD, it is expected that there will be an increase in national output with falling price levels. The factors that affect LRAS are called supply-side factors. This is what the government aims to achieve as they aim to improve productivity in the U.K. economy, e.g. investment in the infrastructure of the economy.
Supply-side factors can be split into two categories: quantitative and qualitative changes. However, government spending can have a significant effect on qualitative changes. For example, investment is a major component in increasing the productive capacity of the economy, by boosting AD. There are many factors that can be invested into to improve production, such as: technological change, improving the quality of human and physical capital – e.g. improving education and training etc.
As explained in extract E, there are clearly other significant benefits that the growth of government expenditure may have on the U.K. economy. One of these is through the process of supply-side fiscal policy. This is highlighted as the ‘promotion of enterprise, innovation, skills and high employment’, as the government aim to improve the supply aspects of the economy. Again, supply side fiscal policy is all about promoting these components and investment, as these supply side factors can improve productivity in the U.K. economy, which in turn should help towards a sustainable economic growth and a low unemployment – e.g. promoting businesses to invest in more workers etc.
Government spending can also have a significant effect on the level of unemployment in an economy. Currently the U.K. economy is facing a recession – 6.3% unemployed, and the government has aimed to intervene by introducing several schemes, such as: subsidising businesses – e.g. the motor car industry, promoting and helping set up job centres, they are also helping to delay mortgage payments, due to the fact many people cannot afford to pay their mortgages at this moment in time due to the economic depression. Therefore, the government are able to use their spending on helping to improve on the levels of employment through a difficult period.
The government can also use Fiscal Policy to influence macroeconomic variables and achieve their macroeconomic objectives. Fiscal Policy is dependent on the changes in the level and composition of both taxation and government spending, which can impact on many variables in the U.K. economy, such as: Aggregate Demand ( C+I+G+(X-M) ), resource allocation and the distribution of income. They can also introduce automatic stabilisers which aim to reduce fluctuations in economic activity. For example if unemployment rises, i.e. during a recession, tax revenue generated will therefore fall due to the loss of workers. In response to this the government may be forced to increase the level of Job Seekers Allowance. Increasing tax revenue can also be useful to reduce the amount of national debt in the U.K. economy. However, during a recession reflationary fiscal policy may be relevant, as the government may be forced to increase expenditure due to the fall in tax revenue caused by higher unemployment etc.
However, Extract F suggests, that there are dangers that too much significant government spending could lead to a massive increase in AD, which could therefore lead to a large rise in the rate of inflation i.e. either above their 2%, plus or minus 1% boundary, or at the maximum/minimum rate. This is relevant to the current situation in the U.K. market where inflation levels have risen to 3% causing the Bank of England to drop interest rates from 5% to 1% in one year.
Another danger of increasing government expenditure is the ‘restriction in consumer choice’. The government realise that consumer confidence is a major contributor to AD; therefore they do aim a proportion of their spending at improving consumer confidence, amongst other things. However, in doing this, they ‘to some extent, they decide what is produced and consumed, rather than the individual’. For example they may decide to spend a large amount of money on promoting certain food and therefore more of this specific food will be produced.
However, as stated before, government expenditure isn’t the only factor affecting the U.K. economic performance. For example, AD consists of other components, - Confidence, Investment and Exports minus Imports. Consumer confidence makes up around 60% of AD and has a major affect on the U.K. economy, simply because if consumers aren’t confident they will not spend as much as is as forecast and they will choose to save their disposable income. Again, this is relevant to the current U.K. market. The Bank of England have the control over interest rates, therefore when there is a lack of demand for goods and services, the BOE can drop their interest rates to help stimulate spending and reduce the amount of people saving their money. With low interest rates, more people are likely to attempt to borrow money from the banks and consume more. However, at the moment, this is another issue due to the fact banks are very reluctant to lend to each other.
Another factor that affects the U.K. economic performance is exchange rates. For example if the sterling to dollar exchange rate is £1 = $2, however the sterling begins to depreciate due to the lack of consumer confidence to £1 = $1.50, exports out of the U.K. will be cheaper for other countries, therefore we begin to lose money to the weaker pound. Not only this but it will also be more expensive to import goods from abroad, therefore there will be a decrease in AD, directly affecting the U.K.’s economic performance.
In conclusion, the growth of government expenditure does have a major implication on the U.K.’s economic performance; however, it isn’t the only factor that affects the country’s economy e.g. consumer confidence in AD. Judging by the government’s macroeconomic objectives, it is fair to say if there is a change in government expenditure it can have a significant effect on their objectives i.e. short and long run economic growth. However, as stated, consumer confidence is the major component of AD and even if there is a significant rise in government spending and intervention, it does not necessarily result in a more efficient economy, as seen currently in the global economic depression.