Evangel's IB Economics Blog

According to “Costa Rica’s government cuts public spending to reduce economic imbalance” from The Costa Rica News, the government of Costa Rica has been spending too much on transference, university funds, pensions, and salaries.

(Figure 1) Increase in government spending in Costa Rica

As Figure 1 shows, the significant increase in government spending can be illustrated as a rightward shift in aggregate demand (AD)* curve. With increase government spending, some of the money spent on transference, education, and others are now covered by the government. This means that the money, which was spent on those fields, is now being used to consume more things, increasing the consumption. As a result of AD shifting to the right, the price level increases from PL1 to PL2, possibly leading to inflation if not solved quickly, and real GDP increases from Y1 to Y2.

However, according to the same article, the government of Costa Rica is facing financial problem. Because of the dramatic increase in government spending, it is in fiscal deficit, the loss of government revenue. They have spent so much that “the fiscal deficit in the first five months of 2010 was around $670 million. This amount was 85% more than the deficit during the same period in 2009.” In order to refill the lost government revenue, Costa Rica is planning to cut government spending as well as taxing other firms, such as “nightlife venues, bars and restaurants.”

(Figure 2) Result of reduction of government spending

As illustrated in Figure 2, this would shift the AD to the left, reducing the inflation created by extensive government spending. This is because when government spending is reduced, less of the money that did not have to be paid has to be payed; as a result, the consumption of different goods or services would decrease. With AD shift to the left, the price level would decrease from PL1 to PL2, and real GDP would also decrease from Y1 to Y2.

* AD = Consumption + Government Spending + Investment + (Export – Import)