Government Spending and Private Investment - Example

GOVERNMENT SPENDING AND PRIVATE INVESTMENT By and Government Spending and Private Investment Introduction National income, according to Mishkin (2009), refers to the total value of final output of all new goods and services produced by a country in any one year. In an open economy, the national income has four major components identified as consumption, private investment, net exports and the government spending or expenditure. The general equation for the national income, Y is given as: Y = C + I + (X-M) + G, where; C = consumption by the household I = investment by private entities other than the government X = exports M = imports G = expenditure by the government An adjustment in any of these components causes a change in other components and the national income in general. Government Spending and Private Investment The relationship between government spending and private investment is clearly shown by the use of the IS – LM model. The IS – LM model stands for investment saving – liquidity preference money supply model. This is an important macroeconomic tool that shows the relationship between the rates of interest and real output in the money market and goods and services market (Michael, 2004). The IS – LM curve is the general equilibrium where both the goods and the money market are at equilibrium. This is demonstrated by the diagram below The goods and services market is represented by the IS curve which is downward sloping. This is because there exist an inverse relationship between interest and the level of investment. Therefore, when interest rate is low, the investment will be high because of the increased demand for investment goods. On the other hand, the money market is represented by the LM curve in the diagram above. When there is a overall upsurge in the goods market as shown by the shift of the IS curve from IS1 to IS2, the real output expands as shown by the corresponding movement of the real output from Y1 to Y2. The IS curve is a variant of the income expenditure model and incorporates the demand for the market interest rate. On the other hand, the LM curve represents the money supply in the economy. Basically, the IS – LM model tries to explain decision making process by the investors having known the amount of money in circulation and the expected interest rate from their investment. Therefore, the equilibrium condition based on this model is attained when the money invested is equal to the money supplied. The IS curve is simply all combination of interest rate, r and real output, Y that brings the output market into equilibrium given that firms have enough capacity to meet demand. On the other hand, the LM curve is simply all combination of interest rate, r and real output, Y that brings the money market into equilibrium given the nominal supply of money and the general price level. There are two key means by which the government finances its expenditure: printing of more money and increase in taxation. Lewis & Pendrill (2004) observed that these two sources of government revenue have significant impact on private investment in the country. This paper is going to look at the impact of each of the option in private investment. Printing of more money increases the amount of money in circulation (supply of money). Increase in money supply causes the market interest rate to fall until a level whereby further increase does not cause a change in interest rate. This is called the liquidity trap of interest rate. At this level, the interest rate cannot be pushed further down by monetary policies of the government. Investment component of the national income has an inverse relationship with the rates of interest. Assuming that the government employs solely the monetary policies to affect the interest rate, at the liquidity trap of interest rate the rate will still be considered high by demanders of investment capital. At this high interest rate, the level of private investment will be low which can only be influenced through a further lower interest rate. This shows that when the spending by the government is increased, it causes a decline in private investment because of the high interest rate. Raising revenue through other sources like taxation also causes a decline in private investment. An investor will always weigh the costs of investment against the benefits of undertaking the investment project. The benefits of an investment project is the net profit after taxation. Therefore, taxation is a major concern for any investor since it will determine how much return he will get from his investment. Therefore, the government has to trade between the two aspects of sources of its revenue to finance its expenditures. In addition, both the government and the private investors are investing in the same citizens (who is the market). This means inclusion of the government investment introduces competition for resources. The increased demand for investment goods causes an increase in price for these goods as per the law of demand and forces of the market (Hilton, 2004). Since the private enterprises are small players and cannot compete effectively with the government, it is driven away from the market due to the unaffordable cost of investment goods. Notice that unlike the government, the private investors cannot raise additional cash for investment through printing of more money. Due to this limitations in raising cash for investment, private investment will reduce. Therefore, from our diagram above, the demand for investment goods represented by the IS curve will shift from IS2 to IS1. This shifting of the IS curve is not caused by changes in interest rate. It is causes by other factors like fiscal policies of the government such as taxation as we have discussed above. Notice that the new IS curve represents a lower input, Y1. When interest rate is high, the movement will be along the IS curve. The IS curve slopes downwards hence when the interest rate is high, the real output will be low. This is because of the inverse relationship between interest rate and private investment. The lower private investment due to high interest rate causes the real output to decline since private investment is one of the major component of real output. Possible Solutions The major aim of the government while undertaking expenditure programs is to avail goods and services that are of significance to the common public at no profit. However, the government is also limited and hence should work together with the private establishment in order to ensure that the citizens are served. The private firms have a profit objective while making an investment and would therefore be attracted to invest in businesses and areas where they will get good returns (Bazerman & Moore, 2009). This is where the government should intervene in order to encourage them to participate in nation building. There are various measures that the government should then take to ensure this. These measures are discussed below. Incentives The government should give incentives like favourable taxation and duty exemptions among others to encourage investment in areas that other investors are shying away from due to harsh weather conditions, low infrastructural development and others. This will ensure that private investment is still high notwithstanding the increased government spending. Public Private Partnership (PPP) This refers to investment projects that are undertaken by both the government and the private investors. In this kind of partnerships, the private investors cannot feel threated by the presence of the government in the sector since they are equal partners and there cannot be a move that can hurt one of the partners. This is a sure way of private investment in sectors that are capital intensive or areas that are considered to be politically risky. For instance, a private entity may be scared from investing in a politically instable country but would invest if in partnership with the government since it is assured of protection. Government Regulation The government should relax some of the strict laws and regulations that make investments in certain sectors prohibitive. This includes reduction in taxes, duties and other revenue collections by the government. This will motivate private entities to invest in businesses that were previously prohibitive and unprofitable thus increasing private investment. Conclusion The IS – LM model is a useful macro-economic that can be used to analyze the effects of increased government spending on private investment. Both the government spending and private investment are components of the national income. A modification in any of the components will always influence a change in the national income. The Increase in government spending has both direct and indirect impact on private investment. The government should be selective in its spending programs in order to avoid driving away the private investment. The government should invest in those sectors that are unattractive to private investors since it is not profit-minded and has the extra capacity and means to enter such sectors. In this way, both the government and the private establishment will achieve their objectives and serve the interests of its citizens. The government should adopt the use of policies that encourages private investment especially by ensuring that the level of interest is monitored since it has a direct consequence to private investment and by extension, the nation income. Reference List Mishkin, F. S., 2009. The Economics of Money, Banking, and Financial Markets. (9th ed.). Harlow, England: FT Prentice Hall. Michael, K. E., 2004. Macroeconomics for Managers. Oxford: Blackwell Publishing Ltd. Hilton, R. W., 2004. Managerial Accounting: Creating Value in a Dynamic Business Environment. New Delhi: McGraw-Hill Publisher. Lewis, R. & Pendrill, D. 2004. Advanced Financial Accounting (7th ed.). Harlow, England: FT Prentice Hall. Bazerman, M. H., & Moore, D. A. 2009. Judgment in managerial decision making (7th ed.). Hoboken, NJ: Wiley. Read More