Economics

Considering the expenditure approach, GDP has four components private consumption, investment, government spending and net exports. Any changes in these four components adjust the GDP, such as increasing the private consumption will shift the GDP level upwards. When private consumption, investment and net exports increase, it actually increases aggregate demand in the economy. Consequently to accommodate increase in demand, output in the economy is increased and hence the GDP. However when government spending is considered, this effect is somewhat ambiguous.

The effect of increased government spending on GDP is somewhat short term whereas in the long term the effect is nullified by two theories crowding out and Ricardian Equivalence. Government finances its increased spending through either debt or taxes. When government takes up debt in the financial market, it increases the interest rates. The increase in interest rate has negative effect on investment component of the GDP. The companies and small businesses hold all their expansionary projects and are discouraged to take additional loan because of higher interest rate. The decrease in private investment counteracts the increased government spending and hence in the long term the GDP level stays the same.

Now suppose the government finances its spending deficit through increase in taxes. The general public will anticipate the tax increase and will try to save their excess money to pay their future taxes even though the tax increase occurs in the long run. The assumption is that the capital markets should be efficient enough to allow people to borrow and save at their will. When people decrease their spending (correspondingly increase the saving), the consumption component of GDP decreases and consequently counteracts the increased government spending. The result is that the aggregate demand remains the same and hence the GDP level. This theory is known as Ricardian Equivalence. The conclusion is that the government spending alone is not enough to control GDP. The consumption and investment should be changed accordingly in order to adjust the GDP.