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Lesson 16: National Debt, Budgets & Governmental Spending (G)

Module 1: Macro Fundamental Analysis

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Video Transcript

so now we’re going to look at the g component of aggregate demand within an economy and when we look at the g component which is government spending we are of course talking about the demand within an economy which comes from the government so it’s that sector of the economy when we look at the three pillars that this component of aggregate demand is coming from so there are three main types of spending that the government engages in first it engages in capital spending and capital spending is just infrastructure spending so money spent by the government on infrastructure projects it could be railway lines it could be airports it could be bridges it could be new roads etc and when the government engages in capital spending when it builds new bridges architects get paid they then go and hire workers so this is money being pumped into the economy this is inflationary this shifts aggregates demand to the right when governments go out and they spend money on infrastructure projects when they build new roads the construction workers get paid the construction companies go out and this in turn may increase their marginal propensity to invest because they now have more money because they’re getting government contracts so they go out and they invest more helping once again to shift aggregate demand to the right so it’s a stimulating measure it stimulates growth and it stimulates inflation it’s an inflationary injection into the economy from the government now we also have current spending so current spending is the maintenance of public service so what is being built in the capital spending area here and it is also the payment of public sector wages so if the size of the public sector increases and the government is paying more money to workers in the public sector then current spending will increase and this again will be inflationary shifting aggregate demand to the right because this will be an increase in incomes if public sector wages are rising for all of those people in the public sector this will in turn increase their marginal propensity to consume so they will go out and spend more because they are being paid more so ceteris paribus this is inflationary for the economy when construction firms maybe the same construction firms who built the roads previously are being paid to come in and repair the roads this may cause them to increase their retained profit so they go out and invest it increases their marginal propensity to invest so an increase in current spending shifts aggregate demand to the right and this stimulates growth and also inflation as we saw previously in the economic models and finally here we have welfare spending this is usually the largest component of government spending and this is the payment of benefits and pensions so this is really pretty straightforward when welfare spending increases more people in the economy have more money in their pockets and as a result of being either wealthier or feeling wealthier they will go out and they will consume more the marginal propensity to consume goes up one person’s expenditure is another person’s income businesses will then hire more workers to meet this increased demand unemployment falls and businesses themselves may once again see greater retained profits and go out and invest causing aggregate demand to shift to the right once more so all of these spending measures here by the government and we saw in the u.s gdp composition is about 18 of gdp any increases in capital spending current spending or welfare spending is inflationary for the economy it’s an injection into the economy shifting aggregates demand to the right and stimulating both growth and inflation and any reduction in capital spending current spending on welfare spending will have the opposite effect shifting a.d to the left contracting growth and adding deflationary pressures within the economy and after welfare spending here we have debt interest spending now this is blue because debt interest spending can only be deflationary it’s not inflationary and the reason is because any money spent servicing debt by the government comes with an opportunity cost so money spent every ten dollars let’s say every one dollar spent servicing debt is a dollar that cannot be spent on capital spending current spending or welfare spending so just as capital spending current spending and welfare spending is an injection into the economy debt interest spending is a withdrawal from the economy so the higher the amount of debt interest spending the greater the shift to the left in aggregate demand because this will decrease the g component in the rest of the economy make sense so if you have a hundred dollars let’s say to spend on capital spending current spending and welfare spending and you only have ten dollars in a year of interest that you need to pay you have ninety dollars to spend on capital spending current spending and welfare spending you could spend 30 on each but if you only had 100 to spend on capital spending current spending on welfare spending and you had 60 or 70 that you had to spend servicing debt you would only be able to spend ten dollars on each you’ll only be able to spend 30 of your budget on capital spending current spending welfare spending so this would by definition reduce capital spending reduce current spending and reduce welfare spending and therefore reducing the g component in adequate demand and demand would start to fall and real gdp would contract as a result now if the government doesn’t have any debt that needs to be serviced so there is no interest repayments to be made and let’s say the government for argument’s sake is debt free this would still not be inflationary it would not be an injection it is just not a withdrawal so in terms of stimulating economic growth and inflation or shifting aggregate demand to the left causing deflation economic contraction you need to think about it in terms of what’s known as injections and withdrawals into the circular flow of gdp so the higher debt interest spending the less money there is to spend on these three components the lower debt interest spending the more money there is to spend on capital current and welfare spending now when governments are engaged in capital spending current spending welfare spending debt interest spending they are creating budgets and in terms of government budgets a budget deficit is when government spending is greater than tax revenue in a fiscal year so g is greater than t so if government spending is greater than tax revenue in a fiscal year this means that the government is borrowing money in order to fund its spending so whenever a government is running a budget deficit they are incurring debt and they have to make interest payments on that debt and debt interest spending will increase unless of course interest rates come down and then taking on extra debt may not actually increase debt interest spending because if the interest rate comes down at the same rate as you are taking on more debt then you will actually just plateau and you will be paying the same amount of debt interest spending so in fact when governments are taking on more and more debt is in their interest to keep interest rates low because it can mean that they can take on more debt without actually increasing their debt interest spending when government spending is less than tax revenue in a fiscal year so g is less than t this is known as a budget surplus so the government does not have to borrow money to fund its spending it is not incurring debt because all of its spending is coming out of collected tax revenues and finally we have national debt so this is the total amount of government debt over time so a good way of thinking about this is the net accumulation of budget deficits because the budget deficit or surplus is simply taking into account a single fiscal year but the national debt over time takes into account the accumulations of all of the consecutive deficits and surpluses so if government spending is a hundred dollars in a year and it’s collecting ninety dollars in tax revenue it has to borrow ten dollars in order to fund its hundred dollar spending within that year if it does that for 10 years it will have a national debt of 100 and of course that’s just looking at it in the most simplistic terms so you can get an understanding of the difference between a deficit and a surplus in a fiscal year and the overall national debt so the net accumulation of budget deficits