Correlation Between Government Expenditure and Inflation

Question: Discuss about theCorrelation Between Government Expenditure and Inflation. Answer: Introduction Inflation refers is the rise in prices of a wide range of goods and services over a certain period of time, especially within one year. Inflation is brought about by a myriad of factors, but it is most likely to happen in a period that is characterized by strong economic activities whereby there is a shortage in supply of goods and services since demand has gone up; this causes the economy to run beyond its productive capacity. I.e. demand exceeds the supply. In Australia, the government has many economic objectives, inter alia, the objective to maintain low inflation rates. The Reserve Bank of Australia (RBA) recommends the maintenance of low inflation rates averaging about 2-3 percent over the duration of a business cycle of a year. On the other hand, it is also argued that the inflation rate should not be lower than the rate of 2-3 percent as stated above because that would be an indication that there is reduced economic growth and resources that would otherwise be employed to enhance Australias productivity are either lying idle or being wasted. As discussed below, this write-up analyzes how an increase in government expenditure can lead to inflations and also what policies can be employed to curb inflation rates that would distort the economy by destabilizing the currency. The Analysis Government Expenditures Effect on Inflation Among the factors that affect the inflation rates is the aggregate demand. Aggregate demand refers to the demand or consumption rate of the goods and services available in the market. In the event that the demand for the goods and services becomes excessively high, there will arise a situation where too much is spent to acquire the few goods and services in the market. This demand will run ahead of the aggregate supply which will then lead to a pervasive shortage of the goods and services. This stretches the economy to its limits, and since production firms would need more resources in order to increase the output and to match up with the demand, the price levels of the goods and services will rise, leading to what is known as demand-pull inflation. Various factors that affect demand inflation include increases in wages which stimulate private consumption, spending and low-interest rates which promote more borrowing and hence more spending. Saville (2008) argues that in the event that the economy deteriorates, the government is more often called upon to take intervention steps to stabilize the economy. In the Keynesian view, the form intervention required is for the government to spend more with the aim of stabilizing the economy and increasing productivity and investment. However, Ezrim et al (2008) explain that using the cointegration analysis and the Granger Casualty Method as applied to the time series data of the United States; there is an indication that public expenditure directly affects the inflation pressures. A reduction in this expenditure ultimately reduces the inflation rate and vice versa. Further, Saville (2008) likens the government to a parasite that sucks the economys blood (wealth) but does not generate any wealth of its own. When the economy is lackluster, it is reasonably expected that the government should suck less blood so that the host (the economy) does not deteriorate further. However, it is at such times that there are more calls for the government to borrow more and to spend more in the guise of stabilizing the economy. Being a fact that no wealth is generated in return, the effect is that the already scarce resources are depleted further to pay for the governments increasing expenses. The government may further opt to acquire stimulus packages in order to finance its additional deficit spending by issuing bonds that will be purchased by banks with newly created money. This increase in money within the economy will necessitate an increase in prices to match the available goods and services. Further, the additional expenditure from the government will add to the aggregate demand thereby increasing the inflationary pressures that will ultimately lead to demand-pull inflation. Policy Measures From the analysis above, it is evident that increased government expenditure is one of the contributing factors to demand inflation. Therefore, there is the need for policies that are aimed at slowing demand inflation. These policies are: Restrictive/Contractionary Monetary Policy and Contractionary Fiscal Policy which are as explained below: Restrictive/Contractionary Monetary Policy This policy is formulated by the Reserve Bank of Australia which by altering the interest rates which ultimately affects the level of national spending. The RBA adopts higher interest rates which would mean that the government will pay more to borrow funds to finance its expenditure. The high credit costs are aimed at discouraging excessive consumption and spending and therefore lowering the aggregate demand which eases the inflationary pressure. Further, the idea of higher interest rates encourages more savings and less spending. These cumulatively reduce general shortages of goods and services and maintain demand inflation at desirable levels. Contractionary Fiscal Policy These policies involves the increase of taxes and/or the decrease in government expenses as a means of reducing inflationary pressures. An increase in taxes is viewed as means of siphoning money from the private sector and may discourage excessive private consumption. The government, therefore, remains more funded instead of relying on debts to fund its expenditures. Further, the increase in taxes can ensure less disposable income and thereby decreasing private consumption rates and ultimately easing inflationary pressures. Alternatively, the Contractionary Fiscal Policy may lead to the attainment of a smaller government budget deficit by decreasing the aggregate spending and demand through limiting government expenditures. Conclusion From the above analysis, it is clear that an increase in government expenditure contributes to the inflationary pressures leading to demand-pull inflation characterized by an increase in price levels. Inflation is known to cause slow economic growth, the weakening of international trading power due to differences between the value of exports and value of imports, and income inequality due to gains and losses of purchasing powers. It is for this reasons and among others that it is necessary for the Reserve Bank of Australia to maintain its objective of ensuring low inflation over the business cycles so as to maintain and improve living standards. To achieve this objective, the Contractionary policies as discussed above should be at all times be employed ad also be applicable to the government to ensure a balance is maintained between sustainable economic growth and increases in prices at a moderate and desirable rate. References Australias Inflation as a Contemporary Economic Issue. (2016). Retrieved 24 September 2016, fromhttps://www.wiley.com/legacy/Australia/PageProofs/ECODU/1_2/c03AustraliasInflationAsAContemporaryEconomicIssue_WEB.pdf Dupor, W. (2016).How Does Government Spending Affect Inflation? Retrieved 25 September 2016, from https://www.stlouisfed.org/on-the-economy/2016/may/how-does-government-spending-affect-inflation Ezirim, C., Muoghalu, M., Elike, U. (2008). Inflation versus public expenditure growth in the US: An Empirical Investigation.North American Journal of Finance and Banking Research,2(2). Feldstein, M. S. (2009).Rethinking the role of fiscal policy(No. w14684). National Bureau of Economic Research. Heath, A., Roberts, I., Bulman, T. (2004). Inflation in Australia: measurement and modeling.The future of inflation targeting, 167-207. Mehraraa, M., Rezaei, S., Soufianib, M. (2016).The Impact of Government Spending on Inflation through the Inflationary Environment, STR approach(p. 155). Retrieved from https://www.worldscientificnews.com/wp-content/uploads/2015/10/WSN-37-2016-153-167.pdf Saville, S. (2008).Government Spending and Inflation | Steve Saville | Safehaven.com.Safehaven.com. 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