2024 H2 Economics Paper 2 Essay 4: Suggested Answers

Government spending is a component of aggregate demand and a direct injection into the circular flow of income, which depicts the movement of income between households, firms, the government, the financial sector and the foreign sector. When the government spends on infrastructure such as schools, hospitals and roads, or on hiring civil servants, it creates jobs and demand, with payments flowing to firms, workers and suppliers and circulating through the economy.

Effects on the components. First, government investment in infrastructure can improve the ease of doing business and attract private investment, which is an additional injection into the flow. Second, some government spending requires imported raw materials such as steel or machinery, which are a leakage because the payments flow out to foreign economies, partly offsetting the domestic boost.

Effects on national income. The increase works through the multiplier effect, where an initial injection leads to a more than proportionate rise in national income as money is respent. For example, $100 million spent on a hospital becomes income for firms and workers, who respend, generating further rounds of income that shrink each round due to leakages from taxes, imports and savings. The size of the multiplier depends on the marginal propensity to consume. If the MPC is 0.8, the multiplier is 1 divided by (1 minus 0.8), which equals 5, so $100 million could raise national income by $500 million. In the short run this raises output and reduces unemployment where there is spare capacity, and in the long run infrastructure, education and healthcare spending can raise productivity and potential national income.