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Government Spending & Fiscal Policy Presented by: Zahra Abdulkadir Amin 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 The scale of government spending Spending by the government can be classified into five main categories: £98.50 Consumption 1- Consumption Debt interest 2- Current grants & subsidies Capital transfers 3- Debt Interest £18.66 £8.25 4- Fixed Investment £3.83 Current grants and subsidies Fixed Investment £66.61 5- Capital Transfers Figure in Billions Only Government consumption & Fixed investment enter the GDP. The rest are transfer payments that do not form parts of the GDP. Transfer payments are a redistribution of income & are nonexhaustive 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. % 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. 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. 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. Public Sector Borrowing Requirement When negative, it’s referred to as the Public Sector Debt Repayment (PSDR). PSBR= PSFD+ Net Lending 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. Observing those two graphs we notice: 1960s: The deficit was small using both measures. A small surplus was then achieved in 19691970. 1970-1974: enormously. the Both measures greatly since 1983. deficit have rose fallen The gap between the two increased due to the massive rise in privatization proceeds. £ Billion 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. Extreme Cases of the Public View Case A Case B Equities as riskier than government bonds & a risk premium is required. Equities are different from bonds . 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. 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. 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. Business Cycle A business cycle represents economywide 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. 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. Calculating the Inflation Tax Inflation makes debtors better off and creditors worse off. Inflation tax can be calculated as: π.NML 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 (r-π).NML= r.NML- π.NML 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. THE GOVERNMENT DEFICIT AND THE NATIONAL DEBT 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. 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. 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. DYNAMICS OF DEBT AND DEIFICTS 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) CONCLUSIONS: POLICY THE SATANCE OF FISCAL 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. Applications on Kuwait Government Spending, 2007/2008 By Economic Scale By Chapter 25.54% 29.63% 42.86% 57.00% 18.23% 13.36% 12.44% 0.93% Salaries Services & Commodities Transports & Installation Construction, Maintenance & Public Expropriation Other Expenses & Transferable payments Current Expenditures Transfer Expenditures Capital Expenditures Consumption Real Nominal Investment Real Nominal 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 Billion KD Development of the Kuwaiti Budget 10 Budget Actual 8 6 4 2 0 -2 -4 -6 -8 -10 Year Government Expenditures Trend by Chapter 7 6 Billion KD 5 4 3 2 1 0 1990 1992 1994 1996 1998 2000 2002 Year Salaries Services & Commodities Transports & Installations Construction & Maintenance Other Expenditures & Transfer Payments 2004 2006 2008 The Kuwaiti Government Budget Financial Year 2007/2008 Revenues (Million KD) Budget Actual Diff. 7,450 870 8,320 17,719 1,304 19,023 10,269 434 10,703 Salaries Services & Commodities Transport & Equip. Installations Construction & Maintenance Others and transfer payments Total Expenses (Million KD) 2,626 1,834 216 2,058 4,567 11,300 2,477 1,768 90 1,206 4,157 9,698 (149) (66) (126) (852) (410) (1,602) Future Generation Reservation Commitments & Expenses Budget Surplus/Deficit 832 12,132 (3,812) 1,903 11,600 7,422 1,071 (532) 3,610 Oil & Gas Non Oil Revenues Total Revenues Expenses (Million KD) 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) SUMMARY OUTPUT Regression Statistics Multiple R 0.95 R Square 0.90 Adjusted R Square 0.88 Standard Error 757.81 Observation s 14.00 ANOVA df Regression SS MS 11.00 Total 13.00 62242100.59 Coefficients Intercept X Variable 1 F 2.00 55925117.49 27962558.74 Residual 6316983.10 Standard Error Significance F 48.69 0.00 574271.19 t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% -2889.91 1008.71 -2.86 0.02 -5110.06 -669.75 -5110.06 -669.75 0.55 0.15 3.77 0.00 0.23 0.88 0.23 0.88 Government Expenditures Actual 12000 Estimated 8000 6000 4000 2000 Year 07 20 06 20 05 20 04 20 03 20 02 20 01 20 00 20 99 19 98 19 97 19 96 19 95 19 94 0 19 Million KD 10000 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+ SUMMARY OUTPUT Regression Statistics Multiple R 0.99 R Square 0.98 Adjusted R Square 0.97 Standard Error 123.05 Observations 14.00 ANOVA df SS MS F Significance F 143.84 0.00 Regression 3.00 6534244.34 2178081.45 Residual 10.00 151420.66 Total 13.00 6685665.01 Coefficient s Standard Error t Stat P-value Lower 95% -456.54 224.06 -2.04 0.07 -955.79 42.71 -955.79 42.71 0.04 0.05 0.73 0.48 -0.08 0.16 -0.08 0.16 Intercept X Variable 1 15142.07 Upper 95% Lower 95.0% Upper 95.0% SUMMARY OUTPUT (Log Form) Regression Statistics Multiple R 0.98 R Square 0.97 Adjusted R Square 0.96 Standard Error 0.02 Observations 14.00 ANOVA df SS MS F Significance F Regression 3.00 0.11 0.04 108.35 0.00 Residual 10.00 0.00 0.00 Total 13.00 0.12 Coefficient s Standard Error t Stat P-value Lower 95% Intercept -0.51 0.25 -2.02 0.07 -1.07 0.05 -1.07 0.05 X Variable 1 0.17 0.27 0.63 0.54 -0.43 0.76 -0.43 0.76 Upper 95% Lower 95.0% Upper 95.0% Government Consumption Expenditures 5000.000 4500.000 3500.000 3000.000 Actual Estimated 2500.000 2000.000 1500.000 1000.000 500.000 Year 07 20 06 20 05 20 04 20 03 20 02 20 01 20 00 20 99 19 98 19 97 19 96 19 95 19 94 0.000 19 Million KD 4000.000