As per the statement of Arrow & Kruz (2013), the governmental expenditure are reflected by the imposition of taxation and rise in the supply of money. In this connection, it can be stated that government expenditure includes the governmental consumption, investment. Governmental spending on the ultimate consumption reflects the Gross domestic product of a country (DeLong & Summers, 2012). In the term of the macroeconomic fiscal policy, it can be stated that rise in the governmental expenditure is the expansionary fiscal policy.
Figure 1: Effect of expansionary fiscal policy and inflation
(Source: Created by author)
The above figure depicted that in case of expansionary fiscal policy, the aggregate demand will also increase. In the above figure, it can be observed that X axis measures the quantity level and the Y axis measures the level of price. Initially the aggregate demand was AD1 and the post aggregate demand curve was AD2. This in turn increases the real GDP rate. The price level also increases. Therefore, it can be stated that the rise in price level within an economy has increased the inflation rate of the country.
As per the Keynesian economy, it can be stated that the increase in the governmental expenditure increases the aggregate demand and the level of the consumption. This in turn increases the level of production of a country. Therefore, Coibion, Gorodnichenko & Wieland (2012) mentioned that the country will mitigate the recession situation and with the rise in time, the inflation rate of the economy will be increased.
Therefore, more specifically it can be stated that with the rise in the governmental spending of a country, the inflation rate will also increase (Coibion, Gorodnichenko & Wieland, 2012). As a result, it can be stated that there is a positive relationship between the governmental expenditure and the rate of inflation of an economy. With the rise in the rate of inflation, the price level of the products or the consumer goods will be enhanced. In the words of Junttila & Korhonen (2012), inflationary situation of a country leads to decrease the purchasing power per unit as well as the real valuation of the exchange rate will also reduce. On the other hand, it can be stated that in case of contractionary fiscal policy, the inflation rate of an economy will be reduced. Arrow & Kruz (2013) added that decrease in governmental spending reduces the overall spending of the commodity and the price level of the commodities will also decrease. In this essence, it can be mentioned that in case of contractionary fiscal policy, the economy may suffer from the deflationary situation (Coibion, Gorodnichenko & Wieland, 2012).
Inflation has both positive and negative impact for the growth of the economy. Inflation rate increases the opportunity cost of holding money. This will in turn reduce the rate of investment. Nevertheless, Coibion, Gorodnichenko & Wieland (2012) argued that with the rapid increase in the rate of inflation of an economy, the situation of hyperinflation may arise. On the other hand, in this context, it can be mentioned that due to massive growth in the supply of money of an economy, the situation of hyperinflation may occur (Junttila & Korhonen, 2012). Then the interest rate of the country will be higher, which has a negative impact on the economy.
Moreover, inflationary situation of an economy can increase the wage rate of the employees. Moreover, DeLong & Summers (2012) opined that rise in the rate of inflation can reflect the unemployment rate of the country. According to the concept of Phillips curve, it can be stated that ere is a trade off between the unemployment rate and the rate of inflation of the country. Therefore, in this essence, it can be stated that higher inflation rate can reduce the rate of unemployment of the economy. In this purpose, it can be stated that the job opportunity within the country will be increased. In the words of Junttila & Korhonen (2012), this will improve the GDP growth of the economy. Therefore, the inflation rate to a certain level can boost up the growth of the economy (DeLong & Summers, 2012).
Arrow, K. J., & Kruz, M. (2013). Public investment, the rate of return, and optimal fiscal policy (Vol. 1). Routledge.
Coibion, O., Gorodnichenko, Y., & Wieland, J. (2012). The optimal inflation rate in New Keynesian models: should central banks raise their inflation targets in light of the zero lower bound?. The Review of Economic Studies.
DeLong, J. B., & Summers, L. H. (2012). Fiscal policy in a depressed economy. Brookings Papers on Economic Activity, 2012(1), 233-297.
Junttila, J., & Korhonen, M. (2012). The role of inflation regime in the exchange rate pass-through to import prices. International Review of Economics & Finance, 24, 88-96.