Analyse and Evaluate the effects of an reduction in government spending on the economy.

 

Government spending is a component of Aggeregate Demand along with Consumption, Investment and Net exports. A reduction in Aggeregate Demand causes firms to produce less output in order to match lower demand. GDP, which measures the the monetary value of all the finished goods and services produced within a country's borders in a specific time period, hence falls. The multiplier effect then states that further rounds of spending are lost which would have been stimulated by the original AD increase.

 

The demand for labour is derived from the demand for goods and services in the economy. So a reduction in AD causes an increase in demand deficient unemployment.

 

In evaluation this increase in demand deficient unemployment in the short run reduces disposable incomes and hence consumption. This harms short term economic growth. However if this unemployment persists in the long run it may lead to a loss of confidence, sense of worth and decline in skills making it hard to contribute to the labour force again. The productive potential of the economy is hurt in the long run. The Long run Aggeregate Supply curve shifts inwards and long run potential of the economy is reduced.

 

The fact that the budget deficit appears to a structural problem means that government spending cuts may be necessary however. A structural budget deficit is one that occurs throughout all periods in the economic cycle. It may worsen in recessions and improve in periods of growth but is always present, causing national debt to rise year on year. The UK appears to be in a structural budget deficit, even in the early 2000’s when the UK was benefitting from sustained economic growth a growing budget deficit still existed and now with growth returning to the economy the budget deficit still persists. Continually running a deficit increases accumulated national debt and places a heavy and unfair burden on future generations as high taxes will have to be paid in order to erode spiralling national debt.

In brief evaluation without reducing government deficit by reducing government spending the UK are forced to offer higher interest rates to attract buyers of debt. This raises the possbility of the UK falling into a debt trap where even more borrowing is required to re-pay high interest payments on accumulated loans. The situtation in Greece is an example where by mid 2011 the governemnt was forced to pay 20% on any increased borrowing.