The Government Is Trying to Increase Employment by Increasing Government Spending. Using a Keynesian Cross Diagram, Explain and Illustrate the Results of This Policy.

The government is trying to increase employment by increasing government spending. Using a Keynesian Cross Diagram, explain and illustrate the results of this policy.

An increase in government spending; a component of aggregate expenditure, will lead to an even greater rise in output and income, through a process known as the multiplier. The Keynesian model explains how output fluctuations are driven by exogenous changes in demand, and lead to additional gains in income.

AE ≡ C + I + G + NX.

Additional government expenditure on goods and services increase demand for firms and lead to their expectations rising, resulting in a requirement to boost output and hence increase employment. The extent to which this is effective depends on the current economic position of the country, the level of spare capacity and the marginal propensity of domestic consumers to spend.

The total effect of the multiplier process can be illustrated diagrammatically. Suppose the government under its new policy increased expenditure by 1 unit. Initially, this would result in an upwards shift in the AE curve (from AE1 to AE2). This constitutes an increase in the current autonomous portion of aggregate expenditure by 1 unit, ceteris paribus, and an income rise of 1 unit. Furthermore, consumers now have extra income, which they choose to consume a portion of. We denote this fraction as c, the marginal propensity to consume. Knowing this, a second round of additional income is generated of value c. At this point, we can determine that total income has risen by 1 + c, at equilibrium point D; which is significant as it exceeds the original increase in government spending that prompted the process. This process continues with consumers then spending a fraction, c, of the additional income generated in the second round that results in an income increase of c*c, eventually reaching an equilibrium at point E.

[pic 1]

In order to apprehend the total change on income, we can rearrange the equilibrium condition:

ΔY = 1/(1-c) x (ΔG+ΔI+ΔNX)

Here the multiplier effect is expressed as 1/(1-c). For example, if the government raised expenditure by £5 billion as seen in Fig 2, the initial effect is a shift in AE1 to AE2 to a point, w, where income and output is at £55 billion. However, the effect of the multiplier process, given MPC is at 0.75, leads to an overall effect of an increase in AE from £50 billion to £70 billion, at

equilibrium point z. [pic 2]

The change in Y equals the product of the government purchases multiplier and the change in government spending: ΔY = [1/(1 – MPC)]*ΔG. Because we know that the marginal propensity to consume MPC is less than one, this expression tells us that a one-pound increase in G leads to an increase in Y that is greater than one.

ΔY = 1/(1-0.75) x (5bn + 0 + 0) = £20 billion

Thus far we can acknowledge that the increase in government expenditure will increase output and income. However, does the rise in output lead to greater employment?