Explain why a change in the budget deficit may lead to a more than proportionate change in aggregate demand.

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Explain why a change in the budget deficit may lead to a more than proportionate change in aggregate demand.

Budget deficit refers to a failure in a government’s spending policy, i.e. they are spending more than they receive in government revenue, meaning that this extra spending will have to be balanced out, mostly by borrowing. A change in the budget deficit will affect the ability for a government to invest money into goods and services that are normally state provided.

The theory of aggregate demand details the total expenditure in the UK, towards UK provided goods/services. Government expenditure is one of the major factors that make up aggregate demand, being able to provide a direct impact (endogenous shocks) i.e. a change to an expansionary fiscal policy, a direct injection into UK spending. Similarly government expenditure can also lead to a fall in aggregate demand, should it wish to pursue a contractionary physical policy which in effect will lower overall UK spending, although this effect may be limited or cancelled out by other factors such as consumer consumption.

An increase in the budget deficit can in certain cases increase aggregate demand, or shift the AD demand curve to the right. This is due to the fact that governments may simply be willing to borrow large sums of money and use this towards government expenditure. In the case of the UK, an example is the construction of the HS2 railway service; the initial cost is likely to be funded by large amounts of borrowing which will increase the budget deficit (estimated to cost the UK £43 billion). While this initial £43 billion is simply being injected into the circular flow of income, at the same time it will create a new infrastructure for the UK: attracting foreign investment, providing thousands of new jobs etc. In effect, this increase in the budget deficit kick-starts the multiplier effect, as while newly hired workers may choose to withdraw some of their income generated from the initial £43b investment, the large majority will be spent on consumption of other products e.g. when these newly hired workers choose to spend 50% of their new income on consumption of UK goods, they are in effect re-spending half the initial investment of £43b towards the UK economy. The cycle in this way continues, as the increased consumption will only drive employment upwards in order to account for the increase; newly employed workers will once again withdraw some of this money, but also continue to use some of it to consume UK goods/services. Overall, this leads to a more than proportional increase in aggregate demand, due to the multiplier effect as described indicating that the initial investment is re-spent in multiple instances throughout the circular flow of income, or multiplied.  

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Similarly, a decrease in budget deficit may have an effect on overall aggregate demand, although this may be somewhat limited. In theory, a decrease in budget deficit can suggest that a government is not willing to borrow money to increase government expenditure; following a contractionary fiscal policy would indicate less spending into public services/infrastructure. While this directly affects aggregate demand, the increased proportional effect comes in the form of another knock-on effect: an indirect effect on employment levels and consumers. For example, while this may have little to no effect in a healthy economy, if unemployment is already extremely high ...

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