What Happens to the Aggregate Demand Curve if Government Spending Decreases?
Changes in government spending affect aggregate demand to a degree that depends on the size of a number called the fiscal multiplier. If government spending decreases, then aggregate demand will shift left, but the fiscal multiplier determines how much aggregate demand will decrease.
Aggregate demand is a measure of the total spending in a national economy. It is composed of four main elements: investment, government spending, consumption and net exports. The aggregate demand curve is a graph of how the relationship between price, on the vertical axis, and quantity of output, on the horizontal axis, affect the total amount of these elements. As price goes up, aggregate demand goes down, giving the aggregate demand curve a downward slope.
The government spending sector of aggregate demand refers to fiscal policy. Fiscal policy is the discretionary spending by government, such as transfer programs, infrastructure spending, purchases of goods and grants. It does not include monetary policy, which is the actions of the central bank to affect the nation's currency. Fiscal policy also includes taxes. Increases in spending or decreases in taxes translate to an increase in aggregate demand, and vice versa.
Each element of aggregate demand has its own multiplier. A multiplier is a mathematical way or representing the fact that money in the economy circulates. For example, when a person buys a pizza for $10, the pizza store owner is $10 richer. If he spends that $10 on some tomatoes for his business, the tomato farmer is $10 richer. Then the farmer buys a new chicken for $10 from the chicken farmer, who saves the money in his bank account. That first payment of $10 generated $30 in income total, for the pizza owner, the tomato farmer and the chicken farmer. Because the money had an effect of three times its original size, the multiplier on that first spending was 3.
Government spending has a multiplier just like everything else. If the multiplier is 4, then a decrease in government spending of $10 million will result in a decrease in aggregate demand of $40 million, and the aggregate demand curve will shift left by $40 million. However, if the multiplier is 0.5 instead, a decrease of $10 million will only produce a decrease of $5 million in aggregate spending. Aggregate demand will always decrease if government spending decreases, but the size of the effect depends on the multiplier.