“It is estimated that the United States (US) government spending plans will add a cumulative 5.3 per cent to the level of Gross Domestic Product (GDP) in the US during 2022 to 2024.”

Explain how an increase in government spending can cause changes in the components of the circular flow of income and in the national income [10]

The circular flow of income shows the flow of income between the different sectors in the economy, as shown in the diagram below:

[Insert Diagram]

In the above diagram, households provide factor inputs which include labour, land, capital and enterprise to firms and in return, they receive factor income (Y) in the form of wages, rent, interest and profits. Firms provide goods and services to households and in return, they receive payments known as consumption expenditure on domestic goods and services (CD). However, not all the factor income received by households return to domestic firms as revenue. Rather, some go to the government in the form of taxes (T), some go to the financial sector in the form of savings (S) and some go to the external sector in the form of imports (M). Taxes, savings and imports are known as withdrawals, which are basically the factor income received by households that does not return to domestic firms as revenue. Further, some of the payments received by domestic firms do not come from households. Rather, they come from the government in the form of government expenditure on goods and services (G), the financial sector in the form of loans to finance investment expenditure (I) and the external sector in the form of exports (X). Government expenditure, investment expenditure and exports are known as injections, which are basically are the payments received by domestic firms that do not come from households. Equilibrium is achieved when injections are equal to withdrawals.

Suppose that injections are equal to withdrawals (J = W) initially. Further suppose that the marginal propensity to consume out of domestic goods and services (MPCD) is 0.8, the marginal propensity to withdraw (MPW) is 0.2 and the increase in government expenditure is $1000. When this happens, injections will be greater than withdrawals (J > W) by $1000. When government expenditure on goods and services increases by $1000, firms will employ more factor inputs from households to increase production and hence will pay households more factor income by $1000. When households’ income rises by $1000, they will increase consumption expenditure on domestic goods and services by $800. Due to the increase in consumption expenditure on domestic goods and services by $800, firms will employ even more factor inputs from households to further increase production and hence will pay households even more factor income by $800. When this happens, households’ income will rise further by $800, which will induce them to further increase consumption expenditure on domestic goods and services by $640. The cumulative rise in expenditure comprises in the initial rise in the government expenditure of $1000, and the further increases in induced consumption of $4000, which will lead to an overall rise in national income by $5000, which is seen in the table below:

[Insert Diagram]

In the above diagram, each time households’ income rises, they will pay more taxes, increase savings and buy more imports. The first round of increase in withdrawals is $200, followed by $160 and will sum up to $1000. When the withdrawals rise to $1000, which equals to the initial rise in injection of $1000 (i.e. rise in government expenditure), equilibrium will be restored and national income will stop rising.

In conclusion, the rise in government spending will lead to a multiplied increase in national income and will affect the components of circular flow: government spending (G), factor income (Y), consumption of domestic produced goods and services (Cd), savings (S), taxes (T) and imports (M).