Relationship between government spending and private consumption since 1992 in India

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 d