Relationship between government spending and private consumption since 1992 in India

Introduction

Whenever there is a fiscal expansion by the government, this further leads to a budget deficit or a surplus. Nominal indices can define the size and influence of the government in pure budgetary terms, but they are unable to capture the effects of the monetary or the fiscal policy of the government. For such measurements, total government spending figures are required to examine and analyse the division of output between the private and public goods and how this spending affects economic growth (Lindauer & Velenchik, 1992). The impact of government spending on the consumption levels of the private sector is one of the major issues that has been discussed for quite some time amongst the economists and policy makers. Consumption is one of the components of Gross Domestic Product (GDP) of any economy. This component is further used to make economic valuations, and this lays down the importance of factors that affect the consumption patterns.

Some empirical research has suggested in the past that the private consumption is crowded in by the increase in government spending. However, this evidence violates neoclassical macroeconomic theory which states that the consumption should decrease with the negative wealth effect and government spending. The basic prediction of the real business cycle (RBC) model is that the private consumption crowds out with the government spending. The standard real business cycle model predicts that the negative wealth effect is created by the rise in government spending which in turn lowers down the permanent income of the household (Baxter & King, 1993). In order to prevent this drop in the consumption patterns, the households tend to substitute this with an increase in their labour supply. However this substitution effect is not that effective to offset the wealth effect. The increase in taxes induced by the rise in government spending reduces the net present value of the disposable income which in turn leads to a decrease in consumption. It has been seen that the models that have nominal rigidities, the increase in government expenditure leads to an increase in consumption. Linnemann and Schabert (2003) as a part of their work had shown that the stickiness alone is not sufficient to explain the rise in consumption. They also concluded that the strength of the demand effect depends majorly on the response of the real interest rate as set by the monetary policy.

Analysis of the effects of the changes in the government spending on the private consumption pattern allows an in-depth understanding of the impact of fiscal policy on the welfare of the people. The largest component of aggregate demand is private consumption. This private consumption evidently is also the principal factor that determines the agents’ welfare. Economic theory is yet to come up with updated guidance on the welfare implications and dynamic effects of the shocks to public spending. Whatever insights that we have so far are totally dependent on the nature of simultaneous changes in policy variables. As per the Keynesian models, private consumption should increase with the rise in the government spending.

The main emphasis of the academic study has been on income and disposable income. The government is the major driver of disposable income and household consumption (Private sector consumption) with the help of tolls and tweaks like fiscal policy contraction or expansion. This project seeks to understand and evaluate the impact of government spending on the private sector consumption in Indian economy. This topic is particularly important and draws attention because private consumption is the largest component of aggregate demand and thus it is taken as one of the most important determinants of the welfare of the nation.  The section of literature review is dedicated to the analysis of the various past works that have been performed on this topic. It is interesting to see how different works draw a relation between the changes in government purchases and the consumption results. As a part of analysis and review, it has been seen that all the works had applied a time series analysis-based approach to calculate the impact on the consumption and other variables when an external rise in the government spending is seen. However the basic assumptions of the models used in these works is the differentiator factor. Different assumptions have been used to identify the different external component of the variable (Galí, López-Salido & Vallés, 2007)

Objective

With the help of this dissertation an effort has been made to understand the impact on consumption patterns. The purpose of this dissertation is to assess the effect of government spending on private consumption in India. To evaluate whether government spending crowds in or crowds out private consumption. Further this dissertation touches upon the study whether the macroeconomic factors that govern the relationship between private consumption and government spending in developed nations are different from those in a developing country like India. This dissertation will help to clearly understand the importance and impact of on-going government spending in India. There are two opposing outlook on the relationship between government spending and private consumption, which include the concept of substitutability, and complementarity. This dissertation will help to assess which view has been more relevant to the Indian conditions.

Literature Review

In the past, the researchers have tried to work on this topic using the data of different timelines and different geographies to draw some meaningful conclusion. The works of some of them have been covered as a part of the limited purview of this research work.  Most of the works have been based upon the structural Vector autoregressive models, with different researchers using different alternative schemes. In the pre Keynesian era, the activities of government were disregarded while performing the analysis of the consumption (Mahmud & Ahmed, 2012). It was Keynes (1936) who explained the importance of the multipliers to generate the outcomes of fiscal shock in the desired form. It was since that time that the consumption has become a quintessential component of the Keynesian analysis. According to his analysis, the rise in the government expenditure results in the creation of increased income opportunities which in turn lead to the rise in effective demand. In Keynesian view, the people who have an additional income tend to consume more and thus there is an increase in aggregate demand. Martin Bailey (1971) introduced the phenomenon of substitutability hypothesis between the private and public consumption. He found that irrespective of the amount the government spends on investment goods or consumption goods; there is a reduction in the total resources that are currently available for the private consumption of the household. The government expenditure works as a substitute for the private consumption and hence one unit increase in the government expenditure would lead to a reduction of an equal amount in private expenditure. According to Bailey, this substitution is unavoidable no matter how the government plans its expenditure.

In contrast to Bailey, the Ricardian Equivalence used to have a different view around the relationship between the government’s activities and the household’s consumption decision. According to Ricardian Equivalence, it is assumed that the households tend to have a perfect foresight, knowledge and information about the economy. They are rational in nature and they can change their consumption plans on a day to day basis depending upon the choices made by the government on debt financing and tax financing. It proposes that the substitution of a budget deficit for current debt and taxes or an alternative arrangement has an equal likely impact on the aggregate demand (Barro, 1989). The Ricardian Equivalence refutes Keynesian Multiplier effect by assuming that any of the fiscal shocks does not have an impact on the consumption savings plan of households. Bailey (1971) contradicted the Ricardian Equivalence by providing an explanation around the substitution between the household and government consumption. According to the Ricardian point of view, the decisions of the consumers are based on the current disposable income as well as the future tax obligations. Another factor of “fiscal signals” perception was added by Feldstein (1982). This factor is said to augment the process of decision making based on how the government and households perceive these fiscal signals. The term fiscal signal refers to any occurrence of the government spending which acts as a shock in one point of time may suggest about the periods of similar or higher spending years to the private sector. These fiscal signals also include the situation of a rise in the taxes in a given year that can provide an indication to the individuals around the possible future taxation rise and payouts, upon which they modify their expectations. However, Feldstein found no evidence of ex ante crowding out after any fiscal expansionary shock.

In their work for IMF, Coenen and Straub (2005) revisited the impact of government expenditure shock on the private consumption using the New Keynesian DGSE model of the EURO area. This work was featuring the non-Ricardian households of the geography. With this study these two researchers had shown that the presence of non Ricardian households is always helpful and conducive in raising the private consumption levels with the increase in government expenditure. However their empirical study indicated a weak chance of crowding in of the private consumption with the increase in expenditure because the overall estimate of the non Ricardian households in the geography was very low. Thus, non-Ricardian households have a major impact on the levels of private consumption.

 References

• Bailey, M. J., (1971). National Income and the Price Level, New York: McGraw-Hill
• Barro, R. J. (1989) “The Ricardian Approach to Budget Deficits” NBER Working Paper No.2685
• Baxter, Marianne, and Robert G. King (1993). “Fiscal Policy in General Equilibrium.” American Economic Review 83, 315-334.
• Coenen, G., & Straub, R. (2005). Does Government Spending Crowd in Private Consumption? Theory and Empirical Evidence for the Euro Area*. International Finance, 8(3), 435-470. doi:10.1111/j.1468-2362.2005.00166.
• Feldstein, M. S. (1982). “Government Deficit and Aggregate Demand”, Journal of Monetary Economics, 9, 1-20
• Galì, J., López-Salido, J., & Vallés, J. (2007). Understanding the Effects of Government Spending on Consumption. Journal Of The European Economic Association, 5(1), 227-270. doi:10.1162/jeea.2007.5.1.227
• Keynes, J.M. (1936). “The General Theory of Employment, Interest and Money”, Macmillan ,London, United Kingdom.
• Lindauer, D., & Velenchik, A. (1992). GOVERNMENT SPENDING IN DEVELOPING COUNTRIES. World Bank Res Obs, 7(1), 59-78. doi:10.1093/wbro/7.1.59
• Linnemann, L., & Schabert, A. (2003). Fiscal Policy in the New Neoclassical Synthesis. Journal Of Money, Credit, And Banking, 35(6a), 911-929.
• Mahmud, M., & Ahmed, M. (2012). Government expenditure and household consumption in Bangladesh through the lens of economic theories: an empirical assessment (Masters). Department of Economics, University of Dhaka, Dhaka.
• Schclarek, A. (2007). Fiscal policy and private consumption in industrial and developing countries. Journal Of Macroeconomics, 29(4), 912-939.