Government Spending & Fiscal Policy

1. Government Spending & Fiscal Policy Presented by: Zahra Abdulkadir Amin

2. CONTENTS • Government Spending • Government Deficit • Adjusting the deficit for inflation & the cycle • Government Deficit and the national debt • The stance of fiscal policy • Applications on Kuwait

3. The scale of government spending • Spending by the government can be classified into five main categories: • 1- Consumption • 2- Current grants & subsidies • 3- Debt Interest • 4- Fixed Investment • 5- Capital Transfers • Only Government consumption & Fixed investment enter the GDP. The rest are transfer payments that do not form parts of the GDP.

4. % • Transfer payments are a redistribution of income & are non-exhaustive to the economy. • Capital transfers are received by businesses as grants. • Debt interests are received as income by individuals or institutions. • The ratio of government consumption to GDP is used to assess the quantity of resources used by the government.

5. When measured using constant and current prices, the ratio of government expenditures to GDP exhibit different fluctuation rates. • The price of government consumption has risen faster than the GDP deflator. • The reason for that is that it’s difficult to measure improvements in the quality of government services. • Improvements are thus measured by the government spending, by adding up the resources used, which fails to reflect the productivity growth.

7. Government investments in the UK roughly halved remaining very law since the 1970s. • The fall in government investment happened because the government was obliged to reduce its spending. • Government spending changes not only as a response to changes in economic policy, but also as a response to structural changes in the economy.

8. THE GOVERNMENT DEFICIT • Measuring the deficit • GD = Total government spending - Taxation. • Either the central government , all government or the whole public sector is included. • The two most important measures are : the Public Sector Financial Deficit (PSFD) and the Public Sector Borrowing Requirement (PSBR). • 1- Public Sector Financial Deficit • Used when we focus on the public sector as a whole. It comprises government spending less income, plus the deficit of public corporations.

9. Public Sector Borrowing Requirement • When negative, it’s referred to as the Public Sector Debt Repayment (PSDR). • The difference between the PSFD and PSBR is the ‘net lending to the private sector and overseas’. This includes net purchases of company securities. • When public corporations are privatized, NL includes the proceeds of privatization (revenues) which make it large and negative. PSBR= PSFD+ Net Lending

10. £ Billion • Observing those two graphs we notice: • 1960s: The deficit was small using both measures. A small surplus was then achieved in 1969-1970. • 1970-1974: the deficit rose enormously. • Both measures have fallen greatly since 1983. • The gap between the two increased due to the massive rise in privatization proceeds.

11. Why does the government deficit matter? • If it’s not financed by an increase in money supply, it must be financed by borrowing. • Large scale borrowing raises interest rates causing the crowding out effect. • How to finance the deficit depends on the public view of shares and bonds.

12. Extreme Cases of the Public View • Case B • Equities are different from bonds . • Issuing equity has no effect on the price of bonds & interest rates. • The focus is on PSBR. • Prices of equities, however, are affected & thus Tobin's q. • Case A • Equities as riskier than government bonds & a risk premium is required. • Either using equities or bonds, interest rates will be raised by just much and rates will rise and fall together keeping RP constant. • The best measure in this case is the PSFD.

13. Adjusting for inflation and the cycle • Government deficit needs to be adjusted for the following: • 1- Inflation tax • Inflation tax is the economic disadvantage suffered by holders of cash and its equivalents due to the effects of inflation. • Since government are the biggest debtors, inflation tax transfers resources from the private sector to the government. • Only the real cost of interest payments should.

14. Business Cycle • A business cycle represents economy-wide fluctuations in production over a long period of time. • Even without any change in government policy, the deficit varies over the cycle. • The cyclical adjustment can be calculated creating the cyclically corrected deficit. • This is the deficit that would occur given full employment, lower benefit payments and higher tax revenues.

15. The structural PSFD shows a deficit in 1970s . • 1970s: The inflation adjusted PSFD shows a surplus. • During the 1980s a deficit emerged due to the fall of inflation reducing the inflation tax. • Main Causes: the large rise in unemployment & the fall in output, reducing the effect of the contractionary policy.

16. Calculating the Inflation Tax • Inflation makes debtors better off and creditors worse off. • Inflation tax can be calculated as: • Where NML= Nominal Government's net monetary liabilities. • If r= average nominal interest rate on government bonds, & r.NML=nominal interest payments then, • Real Interest Payments= Nominal Interest Payment- Inflation Tax π.NML (r-π).NML= r.NML- π.NML

17. Inflation changes yearly. • Calculating the inflation tax using the actual inflation rate can vary greatly. • An inflation rate based on a longer term should be used, called the expected inflation rate. • The same measure should apply to interest rates. • An ex ante inflation tax can be calculated using expected interest rates.

18. Interest payments • It’s argued that government deficits raise interest payments. • The real measure of the cost of debt should be considered. • Throughout the 1970s real interest payments were negative. • The real burden of interest rates increased sharply since 1980s. THE GOVERNMENT DEFICIT AND THE NATIONAL DEBT

19. Government Debt • Note that: • It’s possible to run a deficit without the real value of the debt increasing if inflation is reducing its real vale. • Real Debt will increase only if the inflation-adjusted balance is negative. • If GDP grows at a rate of 12%, the government can run a deficit of 12% of the national debt each year.

20. Also note that: • If the growth rate of GDP (g) exceeds the real interest rate in the long run, the ratio of government debt to GDP will converge to a stable equilibrium. • 1960s: National debt fell as a proportion of GDP and since then has been approximately constant. • The ratio of debt to GDP is self limiting.

21. Real deficit is divided into two parts; the primary deficit and real interest payments: • γGDP+ (r-π) Debt • Dividing by total debt, we obtain the growth rate of the debt: • =(γGDP+ (r-π) Debt)/Debt • =γ(GDP/Debt)+ (r-π) • The ratio of debt/GDP will be constant if they grow at the same rate, thus: γ(GDP/Debt)+ (r-π) = g • From this, it follows that: • Debt/GDP= γ/(g-r-π) DYNAMICS OF DEBT AND DEIFICTS

22. CONCLUSIONS: THE SATANCE OF FISCAL POLICY • Government deficit is the best measure of the stance of the fiscal policy. However, • Spending & Taxation affect the level of aggregate demand independently of the size of the deficit (balanced budget multiplier theorem). • Different types of spending or taxation have different multiplier affects. • The way in which a deficit is financed affects the level of aggregate demand.

23. Applications on Kuwait

24. Government Spending, 2007/2008 By Economic Scale By Chapter

25. Consumption Real Nominal Investment Real Nominal

27. Government Expenditures Trend by Chapter

28. The Kuwaiti Government Budget

29. DETERMINING GOVERNMENT EXPENDITURE MODEL The government expenditures model can be formulated as: G(t)= + Y+  G(t-1)+  Where G(t) is total government expenditures at time t, Y: real output G(t-1) is government expenditures of the previous year and  is the error term. Using those parameters, the results obtained for Kuwait for the period 1994-2007, is: G(t)=-2890 +0.55Y+ 0.20 G(t-1)

32. Estimating the Government Consumption Expenditures Model C(t)= + Y+  C(t-1)+ R+ Where C(t) is the government consumption expenditures, Y the real level of output, R is reserve money, C(t-1) is consumption expenditures of the previous year and  is the error term. Estimating the model, the result obtained is: C(t)=-457 +0.04 Y+ 0.97 C(t-1)+ 0.14R The log form can be taken to estimate the elasticities of the involved parameters, such that: Log C(t)=  + Log Y+  Log C(t-1)+  Log R + Resulting in: C(t)= -0.51 + 0.17Y+ 0.91C(t-1)+ 0.05R+