Evaluate whether higher government spending will always increase inflation.

Government spending is the total spending by government on all goods and services in a given period of time. Inflation is the sustained increase in the general price level over a given period of time. Higher government spending will lead to demand-pull inflation. This is because government spending is a component of aggregate demand (AD). Assuming other determinants of AD remain constant, an increase in government spending will increase the level of AD in the economy. This means that the AD curve will shift to the right. This leads to an increase in the price level, an extension along the aggregate supply (AS) curve, and an increase in real GDP. Hence, a higher level of government spending has increased inflation, seen by the increase in the price level. Higher government spending will lead to inflation due to the multiplier effect. The multiplier effect occurs when an initial change in an injection into the circular flow of income has a greater final impact on national income. Government spending is an injection into the circular flow of income. The government spending filters through to firms and households (e.g. through wages). They in turn spend a portion of this additional income, which flows from firms to households, and vice versa (e.g. households purchase goods and services). This process carries on with smaller and smaller amounts being added to national income as the money flows around the economy. Each additional round includes consumer expenditure and investment, which, being components of AD, shift the AD curve further right. This in turn leads to demand-pull inflation. However, government spending will not increase inflation if there is spare capacity in the economy. If there is a negative output gap, shifts to the right of the AD curve will mean that unutilised factors of production will be used to increase real GDP, and there would be no inflationary pressure. Whether or not higher government spending will always increase inflation depends on which school of thought is adopted. In a Keynesian AD/AS model, spare capacity in the long-run is possible, allowing for increases in AD without inflationary pressure. However, neo-classical economists would argue that in the long-run, any increase in AD will always lead to inflation, due to the nature of their AS curve being vertical. Ultimately, higher government spending is very likely to result in demand-pull inflation, but will not necessarily ‘always’ do so.