International Finance Theory and Policy
by Steven M. Suranovic

Finance 50-10

Effect of an Increase in Government Demand on Real GNP

Suppose the economy is initially in equilibrium in the G&S market with government demand at level G1 and real GNP at Y1, shown in the adjoining diagram. The initial AD function is written as AD(…,G1,…) to signify the level of government demand and to denote that other variables affect AD and are at some initial and unspecified values.

Next suppose the government raises demand for G&S from G1 to G2, ceteris paribus. The increase might arise because a new budget is passed by the legislature with new spending initiatives. The ceteris paribus assumption means that all other exogenous variables are assumed to remain fixed. Most importantly in this context, this means that the increase in government demand is not paid for with increases in taxes or decreases in transfer payments.

Since higher government demand raises aggregate demand, the AD function shifts up from AD(.., G1, ..) to AD(.., G2, ..) (step 1). The equilibrium GNP in turn rises to Y2. (step 2). Thus the increase in government demand causes an increase in real GNP.

The adjustment process follows the GNP too low story. When government demand increases, but before GNP rises to adjust, AD is greater than Y1. The excess demand for G&S depletes inventories, in this case for firms that supply the government, causing merchants to increase order size. This leads firms to increase output, thus raising GNP.

International Finance Theory and Policy - Chapter 50-10: Last Updated on 1/20/05