How Borrowing by EU governments can affect output, employment and inflation
Output, employment and inflation are closely linked, one may possibly lead to another. Therefore, borrowing by EU governments may have an effect on all. If countries that are in deficit are allowed to borrow money from other countries, it will do good on their output level, employment level and causes inflationary effect. This can help the deficit countries to get out of comparatively serious recession and therefore create a stronger euro, which is the main objective of the Growth and Stability Pact (Extract A line 6-7).
As governments borrow money, they will have a more government reserves to invest on the domestic economy like building roads and hospitals or funding domestic firms. These make the economy more productive and efficient. On the other hand, it also creates job opportunities for the local workers. This causes an outward shift of the Productivity Possibility Frontier and a rightward shift of both short and long run aggregate supply curve (rise in income, profit, rent…etc.) resulting a higher output (N1-N2) and employment level as follows:
As the above diagram shows, there will be a deflationary effect causes by the shift in short run aggregate demand, however, the effect is relatively small and slow when comparing to the knock-on-effect on aggregate demand (higher employment level increases consumers’ spending) and the increase in government spending. So the increase in aggregate demand will produce an overall inflationary effect (P1-P2) in short run.
However, this may not always be the case, it depends in which way the government spends, if it spend on non-investment aspects like increase unemployment benefits, it will have an adverse effect on the economy, as it discourage low income workers to work (benefit which they receive from government may be higher than their original income). So employment level may possibly be lower, and causing...