Production Possibility Curve

The above figure depicts that, government spending on goods and services will increase the real
GDP of an economy so overall aggregate demand will go beyond potentiality but the longrun
aggregate supply remains constant which ultimately leads in shifting of aggregate demand curve
to right hence increasing the price level. Therefore, there are no possibilities of increasing the
aggregated supply because the potentiality of the supply for this economy is only point A. Inspite
of the increased aggregated demand, the economy cannot supply as the demand is because of the
maximum limit of the production and supply of the economy is point A so point B and C is
unachievable. Due to more demand and less supply, the availability of goods and services
become scarce which increases inflation.

Conclusion & Recommendations:

The above discussion proves that increase in government expenditure increases the inflation. By
the facts presented above it is known that the inflation rate between 2%-3% is sustainable for an
economy but more than 3% is not good so the government tends to control this inflation. The
best way to control the inflation is to follow appropriate strategies which would encourage to
invest more in productive sector and decrease transfer payments. This will maintain the inflation
between 2%-3% and this is sustainable for an economy. The government may apply two ways to
control the inflation either Contractionary Fiscal Policy or Contractionary Monetary Policy.
Contractionary Fiscal Policy will decrease the government expenditure and increase taxes which
will minimize the aggregated demand and it will control the inflation due to the less demand.
Another method to control the inflation is Contractionary Monetary Policy where government
can minimize the inflation through the reserve bank by decreasing the money supply in the
market and it can be done by increasing the cash rate. The increased cash rate will increase the
market interest rate which decreases the investments, consumptions and export. This decrease
will decrease the aggregated demand and the inflation will come under control.

References

Dupor, W. (10 May, 2016). How does Government Spending Affect Inflation. Retrieved from
https://www.stlouisfed.org/on-the-economy/2016/may/how-does-government-spending-affect-
inflation
Investopedia. (n.d.). Inflation trade. Retrieved from
http://www.investopedia.com/terms/i/inflation-trade.asp
Mulligan, C.B. (2009). Inflation and Government Spending. Retrieved from
http://economix.blogs.nytimes.com/2009/06/10/inflation-and-the-size-of-government/?_r=0
White, L. H. (n.d.). Inflation. Retrieved from http://www.econlib.org/library/Enc/Inflation.html