Transcript The Macroeconomics of Public Expenditure

The Macroeconomics of Public
Expenditures
Vandana Chandra, PRMEP
PEAM Core Course
January 12, 2004
Key Concepts
• Fiscal policy and growth – the
connections, complications and
trade-offs
• Macroeconomic balances
• Debt sustainability
Fiscal policy and growth
• Optimal fiscal policy is one that supports national
objectives – growth and poverty reduction efficiently &
in a sustainable manner
• Components of fiscal policy:
– Revenues – tax, fees, foreign transfers (and grants)
– Public expenditures (PE) – recurrent (public consumption)
and capital (public investment)
• Revenues – public consumption – public investment
= government budget deficit before grants
• Optimal level of fiscal components depend upon (1)
country-specific circumstances (high or low income),
(2) debt situation, (3)fiscal institutions, (4) governance,
(5) capacity in government and private sector etc..
Fiscal policy & growth contd….2
• Links between fiscal adjustment and growth depend
upon the type of economy:
– Fiscal policy strengthens macroeconomic stability which
enables investment and growth
– Fiscal incentives through taxes, subsidies and PE provide
incentives for private sector growth – especially through lower
interest rates, provision of public goods, and service delivery
– Fiscal adjustment increases total factor productivity – of labor
and capital economy-wide
• In most developing countries, the level of PE are
constrained by (a) available revenues; (b) grants; (c)
level of fiscal deficit and its longer term sustainability.
(b) is given and (a) is limited, especially if GNP growth
is low.
Fiscal policy & growth contd….3
• Debt sustainability and size of total debt matter – case
by case basis
• If high and unsustainable debt, cannot use GBD to
finance higher PE and growth without jeopardizing
macro stability
• If low debt, can use higher PE, especially public
investment provided concessional financing is
available, to increase growth. Case by case approach is
needed.
“Fiscal policy has to be tailored to country specific
conditions to foster growth, I.e., a uniform approach to
FP in which all countries are counseled to reduce their
deficits under all circumstances is not appropriate.” –
Baldacci, Clements and Gupta,Finance and Development, December 2003.
Fiscal spending, trade-offs and growth
The achievement of sustainable growth and poverty
reduction is a complex process and determined by the
pattern of growth desired and achieved
Ceteris paribus, PE for sustainable growth presents
various trade-offs:
• Aggregate levels of public consumption and public
investment
• Inter-sectoral public investment – e.g. investment in
human vs physical capital; rural vs urban; water vs
roads
• Between categories of public consumption – wages vs
maintenance expenditures vs subsidies and transfers
Macroeconomic effects of fiscal
deficits
- based on Stanley Fischer and William
Easterly, 1990
Economics of the government
budget constraint (GBC)
• Fiscal policy in an open and globally integrated
economy
• The national income identity – effects of the
fiscal deficit on domestic savings, investment,
current account and growth
• Financing of the fiscal deficit – and the
implications for macro stability
• Debt dynamics – issues of fiscal sustainability
and solvency and long run constraints on fiscal
policy
Fiscal policy in an open economy
• GNP = Y = C + I + (T – G) + X – M
• - [I + (Y – C)] + ( M – X) = (T – G )
• Private investment deficit (PID) + Current
Account deficit = Government budget deficit
(GBD)
• Keynesian idea – to use fiscal spending to raise
GNP during a recession – counter-cyclical
• If perfect international capital mobility, then
only tool is fiscal policy
• If imperfect, then both fiscal and monetary
policy (limited) are available tools
Government Budget Constraints
• Govt. budget deficit (GBD) = (Private
saving – private investment) + (Current
account deficit)
• Link between GBD and CA deficit depends
on monetary policy and X & M elasticity.
Financing of the fiscal deficit – 4 ways
1. Print money – can be inflationary after a point.
Seignorage:1 – 2.5% of GNP (avg.)
2. Foreign reserve use – can lead to an exchange rate
crisis
3. Foreign borrowing - can lead to a debt crisis if
resources are not used productively
4. Domestic borrowing – can lead to an increase in
interest rates and dampen private investment; also a
domestic debt crisis
All are interlinked and affect the macro environment.
Debt dynamics – for how long can a
government run deficits?
• Δ debt /GNP = (prim. deficit/GNP) – seignorage/GNP
+ [real interest rate – GNP growth rate]*debt
• Sustainability – as long as GNP growth > real
interest rate (I)
• If real interest rate>GNP growth, and the prim.
deficit exceeds the amt. that can be financed by
seignorage, debt/GNP will continue to rise until
no one will finance the debt. Deficit will have
to be cut.
Is the deficit sustainable? Needs to be
checked through projections over time
• Sustainability depends on size and rate of economic
growth. India, Pakistan, Malaysia ran high deficits
in 1980-86 (now 11%) with single digit inflation vs
Argentina, Brazil – same deficits, high inflation
because of no growth.
• Are deficits from high public investment
sustainable? No, because there is a danger that
unproductive expenditures will be included.
• Tax and spending efficiency promotes higher
deficits through higher growth.
BUT sustainability is not
equivalent to optimality
• Large and continuing deficits crowd out private
investment and growth
• Large and continuing deficits can become
inflationary if the rate of seignorage is raised to
finance them
Debt dynamics….contd.
• Maximum non-inflationary seignorage possible? Usually 1%
of GNP but in a rapidly growing and financially deep
economy, may be 2.5% of GNP.
• What if real interest rate < growth rate? Debt is eroded over
time through growth, so primary deficits can be financed in
excess of seignorage. A type of Ponzi scheme. East Asia.
• Real interest rates cannot remain below growth rates for
long. Bond markets push up interest rates. Growth declines.
• What if govt. sets interest rate controls? Savers will take their
savings out – capital flight as in LAC.