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Chapter 12: Government Expenditure
Chapter Summary:
This unit, along with the next two chapters, challenges much of the
conventional wisdom about the economic effects of expansionary fiscal policy.
The chapter begins by describing the components of government spending,
making a distinction between government expenditures and transfers.
Historical data from the U.S. is presented, and international comparisons.
Afterward, the theory is developed by the links between two budget constraints:
that of the government, and that of the household. The link between these two
Chapter Outline:
I. Data on Government Expenditure
II. The Government’s Budget Constraint
III. Public Production
A. A Temporary Change in Government Purchases: Theory
B. Wartime Effects on the Economy
i. Employment during wartime
ii. Effects of war on labor supply
iii. Effects of war on the real wage rate
iv. Effects of war on the rental market
Teaching Tips:
1. Students are likely to question the conclusions of the model regarding the
neutrality of permanent government spending on real GDP, real interest rates,
2. When discussing equations (12.3) and (12.4), it may be helpful to review figure
7.1 on page 151 and demonstrate how the budget constraint reacts to various
3. The discussion of the effects of wartime spending is particularly timely,
4. The rather dry discussion on page 305 concerning the efficacy of government
spending compared to private spending does not convey the depth of passion
people feel about “big government”. The late Milton Friedman often asserted
that “No one spends another person’s money as carefully as he spends his own.”
Answers to review questions, pg. 316
1. Transfer payments do not make any claim on GDP but government purchases
do. Both transfers and purchases must be financed as indicated by the
government budget constraint (in our model, this requires money creation or
taxation- later we will consider a third alternative-borrowing.) From the
2. For a detailed description refer to the derivation of the multi-year budget
constraint on pages 170-171. Only in this case we rewrite eq. 7.9 to include the
Answers to problems for discussion, pg. 316-317
3. a. If public and private security guards are perfect substitutes in production,
there should be no impact on GDP. However, because national income accounts
treat government purchases of labor as a final good, the measured GDP will
increase. This is a case of “double counting”.
4. a. Prior to the 1996 revisions, the services provided by the capital would have
added nothing to GDP. If they were given to the private sector and purchased
by the government, GDP would increase. For example if government built a
5. a. Based on the assumptions of the model used in this chapter, we will treat
the government purchase as a reduction in future income (=0). If the capital
6. The explanation provided in the question leads one to believe that business
may have raised prices in anticipation of price controls being imposed. We can
7. When the actual benefits of a policy are difficult to measure, as in the case of
military spending or environmental conservation, it may be difficult to establish
a consensus regarding the efficiency of government purchases. To the extent that
these decisions are determined by special interest groups, the costs may be
