Government spending is a component of AD. Therefore, if we have an increase in G, we would get an increase in AD (AD=C+I+G+X-M)

If AD increased faster than Aggregate Supply, we are likely to get an increase in inflation. We can show this with a simple AD / AS diagram.

Diagram Showing Inflation 

 Note, if AS increased at same rate as AD, then prices may not rise. But, if the fiscal spending causes growth to be above the long run trend rate inflation is very likely.

There is a more complicated reason for fiscal spending causing inflation. I haven’t time to elucidate at moment. But, if government finance debt by selling gilts to the banking sector, this can cause an increase in the money supply and inflation.

Fiscal Spending and Crowding Out.

An increase in government spending can cause crowding out.

1. Resource Crowding out.

To finance the increased government spending, the government need to borrow from the private sector. The Bank of England sell bonds, gilts and other securities to the private sector. Therefore, the private sector lend their money to the government. Therefore, it is argued that the government is increasing their spending, but, only by reducing  private sector spending. (this is disputed by Keynesians)

2. Financial Crowding Out.

The other argument is that government borrowing puts upward pressures on interest rates. To attract enough people to buy bonds, the government need to raise interest rates, to attract enough savers; this can put upward pressure on general interest rates. The higher interest rates can cause lower private sector spending and investment. Resulting in lower private sector output.

• More on Fiscal Policy

I will post the answer on this blog, for everyone to benefit from.

I shall try to answer the economics question and / or point to other resources but please bear in mind.

1. The replies will be guidance and not for duplication. Your essays should always be your own work.
2. My speciality is economics for British A Level standard. My university economics is rusty in parts, because generally I don’t use it in teaching A level economics.
3. I can’t guarantee to always give full answers it also depends on my time schedule.
4. The answers will not necessarily be complete. I know several of my essays on this site could be improved.
5. I will answer as a new post. Check home page of blog for new post. With question and answers
6. If you leave your email in the comments, I can try and let you know (email will not be published)

I studied PPE at Lady Margaret Hall college, Oxford University, and currently work as an Economics A Level teacher. I have also examined several different economic units for Edexcel AS and A2.

If you find the information useful, you are welcome to buy me a coffee

The first Readers Questions has had 100 comments.

Readers Question: what does AD stand for in economic terms??

AD = Aggregate Demand.

Aggregate Demand is composed of various factors C, I, G, X – M

C= Consumer spending

I = Investment (Gross fixed Capital Formation)

G= Government Spending

X= Exports

M= Imports

AD places a crucial role in determining the level of national output in an economy. Although Monetarists will argue it is AS which will determine the long run trend rate of growth.

Readers Question: What are the effects of a decrease in foreign incomes on UK exports, how will this effect the equilibrium level of income and the balance of trade?

Quite a few readers have asked this question. Unfortunately, A Level economics no longer uses the Keynesian 45 degree line approach to solving problems such as this. The last time I used this Keynesian model was quite a long time ago, so I am a bit reluctant to answer this kind of question. Nevertheless I will try offer some ideas.

Firstly, it is useful to understand what is happening from a simple perspective, then we can try to use the Keynesian model.

• A decrease in foreign incomes will cause a fall in UK exports.
• A fall in exports, ceteris paribus, will cause a fall in Aggregated Demand. (AD=C+I+G+X-M) A simple AD/AS diagram would suggest a fall in exports and AD, would lead to lower levels of equilibrium national output.
• If the value of exports falls, and imports stay the same, we would expect a deterioration in the balance of trade (i.e. if imports are greater than exports we will get a bigger deficit or move from a trade surplus to a trade deficit.
• Exports are an injection into the circular flow. i.e something that increase Aggregate Expenditure and Aggregate Demand. If exports falls, we will get a reduction in injections and AD.

The Keynesian 45 degree line.

In the Keynesian model we have a 45 degree line. This is the line that depicts where AE aggregate Expenditure = National Income Y.

We then add a consumption line onto the graph. Here consumption equals C+I+G+X-M. It is also known as the aggregate Expenditure. Therefore, if there is a fall in AE, it will lead to a fall in the equilibrium level of Real GDP. This level of real GDP, maybe less than potential.

Diagram of 45 Degree line.

In our example the AE will fall from (2) to (1)

More notes on Keynesian model at Cliff notes

Readers Question: What will happened to the income of business sector if there is an economic decline in America?

An economic decline in the United States, is pretty much guaranteed to reduce the income of the business sector. The recent falls in the US stock markets are largely due to  expectations of a future downturn in the economy. Lower growth leads to lower profits, therefore dividends decline and shares become less attractive. If the US enters into recession, firms will experience a decline in profitability. This is because:

1. Tendency for price wars to develop in a recession. Low sales encourage firms to cut prices
2. Falling sales will lead to lower revenues.

Some firms will be affected more by the downturn. Firms producing luxury goods (Income elasticity of demand >1) will experience the biggest % fall in demand. This is likely to include manufacturers of luxury cars, 5 star hotels. Firms producing basic necessities will be more insulated from the effects of a recession.

1. How can you show an AD shift left or right, using the circular flow? The conflict in my understanding is W MUST equal J because of identities etc. Yet AD can only move if W>J or J>W. I thought that if that happened, that is macroeconomic disequilibrium. Not a shift. is it disequilibrium (excess supply or demand), that leads to a shift? (like market forces and ordinary D&S diagrams?)

AD = C + I + G + X – M (total demand in the economy)

Keynesian Model

In the Keynesian model we refer to Aggregate Expenditure (E) A different term to the AD / AS model

AD = E = Cd + J

Here J(injections) equals investment (I), Government Spending (G) and Exports (X)

It is true that in Equilibrium J = W injections equal withdrawals.

If there is an increase in injections into the economy. There will be a rise in E (Total Expenditure = AD) causing a rise in National Income.

This means that there will be disequilibrium because J is now greater than W. However, as National Income rises there will also be a rise in withdrawals (W) people save more, pay more tax and spend more on imports

Therefore, W will rise until it equals J. However, now the level of AD=E is higher, also there is an increase in National Income

To put some numbers in to clarify, imagine 200 is going round the circular flow. An extra 30 is injected, therefore an extra 30 is withdrawn. Total flowing round is now 230. Does AD move right or what?

Yes, AD (or E as it called in the Keynesian model) will shift to the right. Initially J is greater than W causing rise in AD.

(Note in the Keynesian 45 degree model the AD curve shifts upwards, which is effectively the same as shifting to the right.)

Readers Question: Critically evaluate the argument for and against the likelihood of an imminent house price correction in UK ?

House prices in the UK have risen much faster than inflation; in the past 6 years average house prices in the UK have more than doubled. This has caused many to speculate that house prices are overvalued and are likely to fall, in the near future, to more realistic levels.

These are the arguments in favour of house prices falls.

House prices have risen faster than average incomes.

This has made it more difficult for first time buyers, especially the younger generation to get on the property ladder. With falling demand for new houses, it is only a matter of time before this is reflected in lower prices.

Rising Interest Rates.

Interest rates have increased 5 times in the past 18 months. This rise in interest rates increases the cost of mortgage payments. Therefore, more people will struggle to make mortgage payments and therefore make renting more attracting than buying. It is also worth noting interest rates have a delayed effect; this means it takes upto 18 months for interest rate increases to have an effect on the economy. Therefore, even if interest rates don’t increase anymore, there will be more people affected by interest rate rises (e.g. those negotiating new fixed rate deals, will see a big increase in cost)

Speculation.

If house price rises have been caused by the fundamentals of supply and demand, there is unlikely to be any correction. However, some experts believe the booming housing market has created a ‘bubble effect’; this means that speculators and foreign investors have been buying houses to try and make capital gains. If the market turns, then these speculators will seek to leave the market and cash in their capital gains. This could make a small correction much bigger. – Falling house prices lead to a fall in confidence and discourage many others from buying.

UK investors may also be alarmed by the experience of the US housing market which has already gone from boom to bust.

Prices overvalued

Evidence suggests that house prices are already starting to fall in some parts of the country. Demand is falling from many areas of the economy. Bovis, the new house builder predicted prices would fall by 3% this year. link – Times

A study by PwC suggested house prices are overvalued by 10% - link BBC. This follows reports from the International monetary Fund IMF, which also states UK house prices are fundamentally overvalued.

However, it is notoriously difficult to decide whether house prices are overvalued or not. For example, back in 2003, many commentators argued house prices were already overvalued. The UK housing market has often defied Market predictions

Credit Crisis

The run on Northern Rock, was due to problems in global credit markets. These problems will have an increasing effect on the UK Housing Market. Basically, US mortgage lenders were too willing to lend risky amounts to sub prime lenders. When the housing market faltered there was a rise in mortgage defaults as people couldn’t pay back their repayments. Therefore, many US mortgage companies went bankrupt. This has made other financial institutions much more wary of offering support for mortgage lending. To summarise it is increasingly difficult to get mortgages, especially risky unconventional mortgages. Therefore, this will make it more difficult for first time buyers to get a mortgage; demand will fall further.

However, UK mortgage lending is generally much stricter than US. At the moment, there is not a significant problem of mortgage defaults. With interest rates unlikely to rise in 2008, affordability is unlikely to deteriorate.

Arguments against falling house prices

1. Shortage of supply.

Supply has failed to meet the rising demand. Thus the house prices are based on market fundamentals. There is no likelyhood of the supply shortage being fixed in the short term. Councils are reluctant to build houses in the UK.

2. Rising Population.

Immigration has helped to boost the UK Population, especially in the south east. This is creating additional demand

3. Demographics.

the rise in the population is being exacerbated by demographic factors which have been increasing the number of households. Basically, the average size of households has been falling. For example, increased divorce rates means that there are more single people living alone.

4. Strong Economy

Unemployment is low, inflation is close to government’s target and economic growth is strong and sustainable. With low inflationary pressures (CPI is currently 1.8%) there is scope for lower interest rates in 2008. This will help the housing market

5. Strong desire to buy

We cannot underestimate the strength of feeling that housing generates in the UK. Despite higher prices, people are still keen to get on the property market. Therefore, there are willing to borrow from different sources such as their parents. This means that the rise in the ratio of house prices / income could actually be more sustainable than people think.
However, there is no guarantee this desire for buying a house will continue forever. A fall in house prices would soon change people’s attitude to buying.

Conclusion

House prices are slightly overvalued and there is a significant element of speculation (such as buy to let). However, it would be a mistake to feel that the housing market is similar to a stock market bubble. There is a strong economic justification behind the rise in prices (simple supply and demand factors). Whilst these factors remain in place, house prices are likely to remain high, although it is likely that they will start to stagnate or grow very slowly.

Unfortunately, for those unable to afford their first mortgage, the situation is unlikely to change in the near future.

• UK Housing Market
  
• Are UK Property prices set to fall?

Q. Is A Strong Canadian Dollar A Good Thing?

This is an interesting question. The effects of an appreciation are good for some aspects of the Canadian economy, but, create problems for Canadian exporters.

• The real winners are Canadian consumers who are able to buy US goods at a much cheaper price. US border towns are reporting booming trade as Canadians make the short trip across the border to buy more goods.
• example: Disney World trip: Oct 2006 cost C$3,839. In Oct 2007, the same holiday would cost C$3,428
• Steak dinner in Detroit : Oct 2006 cost C$129. In Oct 2007 C$107
• The real losers are Canadian exporters and the Canadian tourism industry. The appreciation makes Canadian goods and services appear more expensive to US consumers.
• Exporters are seeing their profit margins squeezed as the US price of their exports increase. There is only so much that profit margins can be reduced and so most exporters have been forced to raise their price.

However, it is worth noting not everything is doom and gloom.

• Exporting to non US countries is mainly unaffected. The strength of the loonie is mainly against the US dollar and not the EURO and Yen. Unfortunately, most of the Canadian trade is with the US.
• The effect of a strong loonie, depends on the price elasticity of demand. If demand is inelastic then a strong dollar will only cause a small % fall in demand. It is worth remembering that part of the loonie’s strength is due to the strong demand for Raw materials. Demand for these exports is very inelastic