Impact of Public Expenditure on Inflation and deflation

By

Arun Pratap Singh

Roll No.19LLB087

Semester: 2ND

Name of the Program: 5 year (B.A., LL.B. / LL.M.)

Subject: Economics - I

Name of the Faculty Member: Abhishek Sinha

yuhujkil

DAMODARAM SANJIVAYYA NATIONAL LAW UNIVERSITY

NYAYAPRASTHA, SABBAVARAM, VISAKHAPATNAM - 531035
ANDHRA PRADESH, INDIA

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 ACKNOWLEDGEMENT-

I would like to thank Abhishek Sinha sir for giving me an opportunity for deeply studying about this
topic. This project is a result of dedicated effort. It gives me immense pleasure to prepare this research
paper.

My deepest thanks to our Lecturer Abhishek Sinha , the guide of the research paper for guiding and
correcting various documents with attention and care. I thank him for consultative help and
constructive suggestion in this research paper. I would also like to thank my parents and colleagues
who have helped me for making this research paper a successful one.

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Contents
SYNOPSIS...............................................................................................................................................4
INTRODUCTION.................................................................................................................................4
OBJECTIVE OF THE STUDY:.................................................................................................................4
SIGNIFICANCE OF THE STUDY:...........................................................................................................4
LIMITATION:......................................................................................................................................4
RESEARCH METHODOLOGY:..............................................................................................................5
Economics of Government Spending.....................................................................................................5
Costs vs. Benefits...............................................................................................................................5
Do Deficits Matter?................................................................................................................................8
Literature on inflation in India...............................................................................................................9
According to Papers in a Phillips-curve framework...........................................................................9
According to Papers in a Lucas-supply-function framework............................................................10
According to Papers in a VAR model................................................................................................11
Government Spend, Economic Growth, Deflation and Inflation in India.............................................13
How much has the government (State and Central) spent, how has it varied and has the
expenditure level changed in response to changes in the context?................................................14
Why does the government cut spending? Does the government spend not help?.........................15
Does the government spend or deficit cause inflation?..................................................................16
Does government expenditure contribute to economic growth?...................................................17
What causes inflation, if the government deficits don’t?................................................................18
What caused the spike and peaking of Government Expenditure during 2009 and 2010?.............19
CONCLUSION.......................................................................................................................................22
BIBLIOGRAPHY.....................................................................................................................................23

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 SYNOPSIS

INTRODUCTION
“High economic growth accompanied by high inflation is a common phenomenon among
many emerging economies. Inflation is one of the major problems that may hurt the
favourable growth prospect of emerging economies in Asia. This paper investigates the long-
run and short-run impact of government spending on inflation in three Asian emerging
economies including India, Indonesia and Vietnam by applying the co integration and Vector
Error Correction Model to time series data for the period 1970-2010. The results from both
bivariate and tri-variate models suggest that government spending does have a statistically
significant and positive effect on inflation in the long-run in all three countries. This implies
that the differences in institutions and governance system of these countries hardly affect the
long-run impact of government spending on inflation. In the short-run, there is a co
integrating relationship between government spending and inflation, which is either a direct
or an indirect link through interactions with GDP per capita or nominal exchange rate. For
India, government spending appears to have positive short-run impact on inflation, which is
consistent with the Keynesian view1.”

OBJECTIVE OF THE STUDY:

To study about the public expenditure and their impact on inflation and deflation. Further, the
research study aims at understanding and comprehending the impacts of them on the
economy, especially in the Indian view.

SIGNIFICANCE OF THE STUDY:

The study would help us to understand what public expenditure impacts on inflation and
deflation and the what measures government has taken to maintain irregularities.

LIMITATION:
“This research paper is done relying on articles and essays published by authors online and
books written relating to the subject matter. Though such books are referred they do not
contribute to the bulk of the research and my research is mostly confined with the online

1
Mohsen mehsera, The Impact of Government Spending on Inflation through the Inflationary Environment, STR
approach

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sources. The area of research is restrained only to the concept of legal aid and its present day
challenges.”

RESEARCH METHODOLOGY:
“The research methodology adopted for the purpose of this project is the doctrinal method of
research. The various library and Internet facilities available have been utilized for this
purpose, which include many secondary resources as cited in the bibliography section.”

Economics of Government Spending

“Economic theory does not automatically generate strong conclusions about the impact of
government outlays on economic performance. Indeed, almost every economist would agree
that there are circumstances in which lower levels of government spending would enhance
economic growth and other circumstances in which higher levels of government spending
would be desirable.

If government spending is zero, presumably there will be very little economic growth because
enforcing contracts, protecting property, and developing an infrastructure would be very
difficult if there were no government at all. In other words, some government spending is
necessary for the successful operation of the rule of law. Economic activity is very low or
non-existent in the absence of government, but it jumps dramatically as core functions of
government are financed. This does not mean that government costs nothing, but that the
benefits outweigh the costs2.”

Costs vs. Benefits

“Economists will generally agree that government spending becomes a burden at some point,
either because government becomes too large or because outlays are misallocated. In such
cases, the cost of government exceeds the benefit. The downward sloping portion of the curve
in Figure 1 can exist for a number of reasons, including:”

 The extraction cost

“Government spending requires costly financing choices. The federal government cannot
spend money without first taking that money from someone. All of the options used to
finance government spending have adverse consequences. Taxes discourage productive
behaviour, particularly in the current U.S. tax system, which imposes high tax rates on work,
saving, investment, and other forms of productive behaviour. Borrowing consumes capital
2
Ibid.

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that otherwise would be available for private investment and, in extreme cases, may lead to
higher interest rates. Inflation debases a nation’s currency, causing widespread economic
distortion.”

 The displacement cost

“Government spending displaces private-sector activity. Every dollar that the government
spends necessarily means one less dollar in the productive sector of the economy. This
dampens growth since economic forces guide the allocation of resources in the private sector,
whereas political forces dominate when politicians and bureaucrats decide how money is
spent. Some government spending, such as maintaining a well-functioning legal system, can
have a high “rate-of-return.” In general, however, governments do not use resources
efficiently, resulting in less economic output”

 The negative multiplier cost

“Government spending finances harmful intervention. Portions of the federal budget are used
to finance activities that generate a distinctly negative effect on economic activity. For
instance, many regulatory agencies have comparatively small budgets, but they impose large
costs on the economy’s productive sector. Outlays for international organizations are another
good example. The direct expense to taxpayers of membership in organizations such as the
International Monetary Fund (IMF) and Organisation for Economic Co-operation and
Development (OECD) is often trivial compared to the economic damage resulting from the
anti-growth policies advocated by these multinational bureaucracies.”

 The behavioural subsidy cost

“Government spending encourages destructive choices. Many government programs

subsidize economically undesirable decisions. Welfare programs encourage people to choose
leisure over work. Unemployment insurance programs provide an incentive to remain
unemployed. Flood insurance programs encourage construction in flood plains. These are all
examples of government programs that reduce economic growth and diminish national output
because they promote misallocation or underutilization of resources.”

 The behavioural penalty cost

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“Government spending discourages productive choices. Government programs often
discourage economically desirable decisions. Saving is important to help provide capital for
new investment, yet the incentive to save has been undermined by government programs that
subsidize retirement, housing, and education. Why should a person set aside income if
government programs finance these big ticket expenses? Other government spending
programs Medicaid is a good example generate a negative economic impact because of
eligibility rules that encourage individuals to depress their incomes artificially and
misallocate their wealth”

 The market distortion cost

“Government spending distorts resource allocation. Buyers and sellers in competitive markets
determine prices in a process that ensures the most efficient allocation of resources, but some
government programs interfere with competitive markets. In both health care and education,
government subsidies to reduce out-of-pocket expenses have created a “third-party payer”
problem. When individuals use other people’s money, they become less concerned about
price. This undermines the critical role of competitive markets, causing significant
inefficiency in sectors such as health care and education. Government programs also lead to
resource misallocation because individuals, organizations, and companies spend time, energy,
and money seeking either to obtain special government favors or to minimize their share of
the cost of government.”

 The inefficiency cost

“Government spending is a less effective way to deliver services. Government directly

provides many services and activities such as education, airports, and postal operations.
However, there is evidence that the private sector could provide these important services at a
higher quality and lower cost3. In some cases, such as airports and postal services, the
improvement would take place because of privatization. In other cases, such as education, the
economic benefits would accrue by shifting to a model based on competition and choice.”

 The stagnation cost

“Government spending inhibits innovation. Because of competition and the desire to increase
income and wealth, individuals and entities in the private sector constantly search for new
options and opportunities. Economic growth is greatly enhanced by this discovery process of
3
Lakeri, The Effect of Government Expenditures on Economic Growth

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“creative destruction.” Government programs, however, are inherently inflexible, both
because of centralization and because of bureaucracy. Reducing government or devolving
federal programs to the state and local levels can eliminate or mitigate this effect”

“Spending on a government program, department, or agency can impose more than one of
these costs. For instance, all government spending imposes both extraction costs and
displacement costs. This does not necessarily mean that outlays either in the aggregate or for
a specific program are counterproductive. That calculation requires a cost-benefit analysis””

Do Deficits Matter?

The Keynesian Controversy

“The economics of government spending is not limited to cost-benefit analysis. There is also
the Keynesian debate. In the 1930s, John Maynard Keynes argued that government spending
—particularly increases in government spending—boosted growth by injecting purchasing
power into the economy. According to Keynes, government could reverse economic
downturns by borrowing money from the private sector and then returning the money to the
private sector through various spending programs.”

“This “pump priming” concept did not necessarily mean that government should be big.
Instead, Keynesian theory asserted that government spending—especially deficit spending—
could provide short-term stimulus to help end a recession or depression. The Keynesians even
argued that policymakers should be prepared to reduce government spending once the
economy recovered in order to prevent inflation, which they believed would result from too
much economic growth. They even postulated that there was a trade-off between inflation
and unemployment (the Phillips Curve) and that government officials should increase or
decrease government spending to steer the economy between too much of one or too much of
the other4.”

“Keynesian economics was very influential for several decades and dominated public policy
from the 1930s–1970s. The theory has since fallen out of favour, but it still influences policy
discussions, particularly on whether or not changes in government spending have transitory
economic effects. For instance, some lawmakers use Keynesian analysis to argue that higher
or lower levels of government spending will stimulate or dampen economic growth.”

4
Ibid.

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The “Deficit Hawk” Argument

“Another related policy issue is the role of budget deficits. Unlike Keynesians, who argue
that budget deficits boost growth by injecting purchasing power into the economy, some
economists argue that budget deficits are bad because they allegedly lead to higher interest
rates. Since higher interest rates are believed to reduce investment, and because investment is
necessary for long-run economic growth, proponents of this view (sometimes called “deficit
hawks”) assert that avoiding deficits should be the primary goal of fiscal policy.”

”While deficit hawks and Keynesians have very different views 0n budget deficits, neither
sch00l 0f th0ught f0cuses 0n the size 0f g0vernment. Keynesians are s0metimes ass0ciated
with bigger g0vernment but, as discussed ab0ve, have n0 the0retical 0bjecti0n t0 small
g0vernment as l0ng as it can be increased temp0rarily t0 jump-start a sluggish ec0n0my. By
c0ntrast, the deficit hawks are s0metimes ass0ciated with smaller g0vernment but have n0
the0retical 0bjecti0n t0 large g0vernment as l0ng as it is financed by taxes rather than
b0rr0wing5.””

“The deficit hawk appr0ach t0 fiscal p0licy has always played a r0le in ec0n0mic p0licy, but
p0litics s0metimes plays a r0le in its usage. During much 0f the p0st–W0rld War II era,
Republicans c0mplained ab0ut deficits because they dispr0ved 0f the spending p0licies 0f the
Dem0crats wh0 c0ntr0lled many 0f the levers 0f p0wer. In m0re recent years, Dem0crats
have c0mplained ab0ut deficits because they disappr0ve 0f the tax p0licies 0f the
Republicans wh0 c0ntr0l many 0f the levers 0f p0wer. Presumably, many pe0ple genuinely
care ab0ut the impact 0f deficits, but p0liticians 0ften use the issue as a pr0xy when fighting
over tax and spending policies in Washington.””

Literature on inflation in India

“Existing literature 0n inflati0n in India includes papers in a Phillips-curve framew 0rk,

papers in a Lucas-supply-functi0n framew0rk, and papers that treat inflati0n as a variable in a
larger system 0f equati0ns 0r in a vect0r aut0regressive (VAR) m0del.”

Acc0rding t0 Papers in a Phillips-curve framew0rk

“Papers in a Phillips-curve framew0rk examine the relati0n between inflati0n and the 0utput
gap. 0ut 0f them, the 0nly paper that explicitly attempts t0 estimate the Phillips curve f0r

5
Supra, note 1

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India is, Dh0lakia (1990).Studying a sample fr0m 1950 t0 1985, Dh0lakia asserts that the
Indian ec0n0my d0es n0t seem t0 face any appreciable trade-0ffs between unempl0yment
and inflati0n even in the sh0rt run. He argues that the least-devel 0ped c0untries having
underutilized p0tential w0uld n0t experience inflati0nary pressures if the pace 0f gr0wth is
high. Referring t0 India, Dh0lakia c0ncludes, an imaginary seri0us trade0ff between
inflati0n and unempl0yment, in all pr0bability, is n0t likely t0 exist.‘‘Bhalla (1981) fails t0
find any evidence 0f a significantly p0sitive relati0nship between inflati0n and excess
demand in the Indian ec0n0my. Bhalla c0mments, ̳ ̳Aggregate changes in real 0utput
apparently have n0 effect 0n the inflati0n rate.‘‘ Studying India‘s manufacturing sect0r 0ver
the peri0d fr0m 1961 t0 1977, Rangarajan (1983) asserts a negative c0rrelati0n c0efficient
between price change and real-0utput change. Based 0n Indian yearly data fr0m 1950 t0
1988, Bhattacharya and L0dh (1990) find a weak and negative relati 0nship between inflati0n
and 0utput gr0wth. They als0 refer t0 Bhattacharya (1984) wh0 argues that the Keynesian
Phillips curve d0es n0t w0rk in devel0ping c0untries like India. Ghani (1991) estimates a
price equati0n f0r India 0n a sample fr0m 1967 t0 1982. The equati0n sh0ws a negative sign
0n 0utput. Balakrishnan (1991) w0rks 0n a sample fr0m 1950 t0 1980 in the Indian
manufacturing sect0r. By regressing inflati0n 0n the 0utput gap 0r the ̳activity‘ variable,
Balakrishnan finds a significantly negative relati0n, which clearly c0ntradicts the Phillips
curve f0r India. In an0ther study 0n a sample fr0m 1951 t0 1990, Nachane and Laxmi (2002)
find a negative relati0n between inflati0n and the 0utput gap. Brahmananda and Nagaraj
(2002) in their claims that the c0rrelati0n between inflati0n and gr0wth, if any, is 0ften
negative in Indian data fr0m 1970 t0 1999. Using the quarterly data fr0m 1983Q1 t0 2001Q4
0n 0utput series c0nstructed by Virmani and Kap00r (2002) and Virmani (2004) finds a
negative relati0n between the 0utput gap and inflati0n.”

According to Papers in a Lucas-supply-function framework

“Acc0rding t0 Papers in a Lucas-supply-functi0n framew0rk attempt t0 see the 0utput gap in
resp0nse t0 inflati0n in India. F0ll0wing Lucas (1973), Arak (1977) and Makin (1982) 0ne
study by Samanta (1986) finds a negative relati 0n between the price level and real 0utput in
India. Samanta (1986 attempts t0 estimate an expectati0ns adjusted supply functi0n (EASF)
f0r India using yearly data fr0m 1952 t0 1983. The EASF hyp0thesis states that price change
affects real 0utput 0r supply 0nly when such price change is purely unanticipated Lucas
(1973), Samanta‘s estimati0n, which d0es n0t justify the EASF f0r India finds a significantly
negative relati0nship between price surprises and 0utput.”

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According to Papers in a VAR model
“Acc0rding t0 Papers in a VAR m0del examine the interrelati0nship 0f 0utput gr0wth,
inflati0n, and m0ney gr0wth in India. Rangarajan and Arif (1990) using annual data 0ver the
peri0d fr0m 1961 t0 1985 c0nclude that the price level has n0 resp0nse t0 the changes in real
0utput. Das (2003) w0rking with m0ney, price, and 0utput 0f India 0ver the peri0d fr0m
April 1992 t0 March 2000 sh0ws a negative relati0nship between price and 0utput. 0verall
m0st papers, especially papers that clearly f0cused 0n the Phillips curve, d0 n0t sh0w that a
Phillips curve exists f0r India. A few papers discuss supply sh 0cks faced by India with0ut
adequately inc0rp0rating them in estimating inflati0n. Thus, three lines 0f arguments in
explaining inflati0n dynamics in India can be 0bserved. First, supply sh0cks are held
resp0nsible as a vital fact0r in determining Indian inflati0n Balakrishnan 1991;Dh0lakia
1990; G0yal and Pujari 2004;Ramachandran 2004; Sec0nd, 0ne gr0up believes that
c0untercyclical m0ney wage is the answer t0 the negative relati0n between inflati0n and the
0utput gap( Ahluwalia 1979;Balakrishnan 1991; R0y and Darbha 2002) Third, an0ther gr0up
believes that real marginal c0st is n0t p0sitively c0rrelated with 0utput in India (Chatterji
1989).The first reas0ning w0uld imply that the Phillips-curve the0ry actually fits India, if
supply sh0cks are pr0perly acc0unted f0r. The sec0nd reas0ning implies that firms in India
generally d0 n0t set prices t0 maximize pr0fit. The sec0nd and the third reas0ning, if true,
w0uld imply that c0nventi0nal macr0ec0n0mics, as applies t0 the US, cann0t fit India. If the
first reas0ning is true, which means we can estimate the Phillips curve f 0r India by
c0ntr0lling supply sh0cks, the sec0nd and the third reas0ning bec0me c0ntradict0ry 0r
redundant6. T0 examine the first reas0ning, it is imperative at this p0int t0 see the maj0r
supply sh0cks t0 the Indian ec0n0my.”

S0me studies claim that India‘s ec0n0mic ref0rm br0ught a significant change in the nature
0f the Phillips curve Bhattacharya and Mitra 1997;Paul and Bhanumurthy 1999; Ra 0 2002)
claims that the Phillips curve emerges 0nly in the p0st-ref0rm era.

“In the first gr0up 0f m0dels (R0mer (1993) and Lane (1997)), increased 0penness t0 trade
l0wers inflati0n by making the Phillips curve steeper, i.e. the 0utput-inflati0n trade0ff
smaller; underlying this mechanism is the negative terms 0f trade effect 0f a real
depreciati0n, which is triggered by a m0netary expansi0n. R00mer‘s m0del applies mainly t0
c0untries that are large en0ugh t0 affect internati0nal prices. Lane (1997) sh0ws that this is
n0t a necessary assumpti0n; using a m0del with imperfectly c0mpetitive g00ds markets and
6
R.G. Hawtrey, Public Expenditure and Trade Depression.

11 | P a g e
sticky prices in the n0n-tradeables sect0r he sh0ws that the 0utput gains fr0m unexpected
inflati0n are smaller in m0re 0pen ec0n0mies.”

Again, 0ne w0uld expect 0penness t0 be ass0ciated with l0wer inflati0n and a smaller 0utput-
inflati0n trade0ff. A further implicati0n 0f Lane (1997) is that – f0r a given level 0f 0penness
– the larger a c0untry, the m0re reduces the terms 0f trade effect the benefits fr0m surprise
inflati0n. A negative effect 0f c0untry size 0n inflati0n w0uld p0int t0 the relevance 0f this
effect.

“The sec0nd class 0f m0dels is pr0vided by Daniels and VanH00se (2006) and Razin and
L0ungani (2007). In the m0del by Daniel and VanH00se (2006), characterized by ec0n0my
wide m0n0p0listic c0mpetiti0n, increased 0penness reduces the pricing p0wer 0f d0mestic
firms. As a c0nsequence the 0utput-inflati0n trade0ff bec0mes larger. At the same time, the
reduced pricing p0wer l0wers the 0utput effects, induced by unexpected price increases
thr0ugh a m0netary expansi0n. Hence, 0ne w0uld expect 0penness t0 trade t0 be ass0ciated
with l0wer inflati0n and a larger 0utput-inflati0n trade0ff. Als0 n0te that the m0del predicts
that a higher sensitivity 0f d0mestic spending with respect t0 a real depreciati0n reduces the
0utput-inflati0n trade0ff but increases the inflati 0n bias. In larger c0untries, where trade is a
smaller share 0f d0mestic spending, terms 0f trade changes have l0wer 0utput effects ceteris
paribus. Hence, c0untry size sh0uld reduce the inflati0n bias and increase the sacrifice rati0.”

“Many papers have estimated directly the impact 0f inflati0n 0n gr0wth, 0utput, investment
and pr0ductivity. In this literature, the gr0wth rate 0f the ec0n0my is c0nsidered as the
dependent variable and the inflati0n rate as the explanat0ry variable. The empirical results
have a clear p0licy implicati0n: if inflati0n affects gr0wth negatively, then m0netary p0licy
0ught t0 stress price stability based 0n vig0r0us anti-inflati0nary p0licies targeting zer0
inflati0n.5 Examples 0f papers that have attempted t0 f0ll0w this line 0f research are Smyth
(1992, 1994, and 1995), De Greg0ri0 (1993), and Barr0 (1995)7. Smyth (1992) has estimated
a negative relati0nship between inflati0n and gr0wth: f0r each 0ne percentage p0int increase
in the USA inflati0n the annual gr0wth rate is reduced by 0.223%. Smyth (1994) has als 0
sh0wn that inflati0n accelerati0n impacts gr0wth negatively in the USA, each 0ne percentage
p0int increase in accelerati0n causing a reducti0n 0f 0.158% in gr0wth.”

F0r Germany, Smyth (1995) has estimated that a 10% increase in the rate 0f inflati0n reduces
the rate 0f gr0wth 0f t0tal fact0r pr0ductivity by 0.025%. Camer0n et al. (1996) test the
7
Ibid.

12 | P a g e
r0bustness 0f this kind 0f estimati0n and their results are suggestive that there is n0
c0nnecti0n between inflati0n and the level 0f pr0ductivity.

Government Spend, Economic Growth, Deflation and Inflation in India

“India is a l0w-middle inc0me c0untry, with nearly 2/3rd 0f its p0pulati0n living in rural
areas. It is a y0ung c0untry t00, with median age being less than 30 years. Given its size and
the stage 0f devel0pment, it needs a large am0unt 0f investment in physical, ec0n0mic and
s0cial infrastructure. India als0 has 0ne 0f the largest p0pulati0ns 0f p00r pe0ple in the w0rld.
The g0vernment is n0t 0nly a significant driver 0f ec0n0mic activity, it als0 pr0vides
ec0n0mic and financial supp0rt t0 under-pr0vided and disadvantaged c0mmunities and
regi0ns thr0ugh vari0us schemes and pr0grammes.”
“In this paper, the researcher intend t0 study the c0nsistency 0f aggregate g0vernment spend,
given the impact 0f uncertainty caused by adverse external and natural c 0nditi0ns. The
adverse internal and external events include the Asian financial crisis (1997), d 0t-c0m bubble
burst (2001), gl0bal financial crisis (2007) and the frequent dr0ughts (2002, 2004, 2009, 2014
and 2015). We bring a l0ng-term perspective t0 0ur analysis by c0vering the p0st-
liberalisati0n peri0d. It is ab0ut 25 years ag0, during the early 90s that India embarked up0n
building a market-based ec0n0mic system. During this peri0d, the c0untry has gr0wn at a
much faster rate than any time earlier. At the same time, we d 0 have pe0ple expressing
c0ncerns ab0ut the impact 0f these p0licy ch0ices 0n equity 0f 0pp0rtunity, distributi0n 0f
inc0me and wealth and 0n quality 0f life f0r a maj0rity 0f pe0ple in India8.”
The ec0n0mic p0licy pursued by the p0litical parties, wh0 have g0verned India during the
peri0d under study, has been similar. There has, 0f c0urse, been a difference in emphasis and
the appr0ach in s0me situati0ns. We will highlight these aspects wherever relevant, but the
0bjective 0f 0ur analysis is ap0litical.

We expect the g0vernment res0urce all0cati0n and ec0n0mic and s0cial p0licy ch0ices t0 be
c0nsistent with each 0ther and the c0ntext in which India lives and als0 help enhance India’s
capability t0 gr0w, take and manage risk and deal with uncertainty.

The present research paper c0vers the analysis 0f aggregate expenditure and evaluates the
impact 0f changes in expenditure level 0n deflati0n, inflati0n and gr0wth, given the p0licy
c0ntext.

8
Somer Anderson, Why Is Deflation Bad for the Economy?

13 | P a g e
 “H0w much has the g0vernment (State and Central) spent, h0w has it varied and has
the expenditure level changed in resp0nse t0 changes in the c0ntext?
The state and the central g0vernments have spent, 0n an average, an am0unt equivalent t0
28.94% 0f the GDP (measured at current market prices) 0n devel0pment and the n0n-
devel0pment expenditure, making them the biggest spender in the ec0n0my. While it was the
l0west level at 26.1% during 1997, it reached a peak 0f 32.0% 0f GDP during 2010. Since
reaching its peak, the expenditure level has fallen t0 27.9% during 2016. It is interesting t0
n0te that the expenditure (% 0f GDP) during 2016 is just marginally higher than what it was
during 1996. Given the GDP level in 2016, a 0ne percent decrease in g0vernment expenditure
implies a reducti0n in spending 0f ab0ut USD 20 billi0n,”.

In resp0nse t0 a dr0ught, the g0vernment did raise the expenditure level during 2010 and
2015 (years immediately f0ll0wing the dr0ught years) but f0ll0wed it by a reducti0n during
the immediately f0ll0wing year.

We have had 2 c0nsecutive years 0f dr0ught during 2014 and 2015. While the
g0vernment expenditure level did g0 up during 2015 by 0.8%, it was f0ll0wed by a
decline 0f 2.9% during 2016 – a decline 0f nearly USD 58 billi0n at 2016 GDP level.
We w0uld ask the f0ll0wing questi0n in this c0ntext:

 Is it sufficient t0 raise the expenditure during the year 0f dr0ught 0r d0 we need t0

invest c0nsistently 0ver a l0nger peri0d f0r building the capability t0 deal with the next
dr0ught situati0n 0r any situati0ns that cause high degree 0f uncertainty?
 Are there any c0nstraints that d0n’t all0w the g0vernment t0 invest c0nsistently when
required?
A similar situati0n 0f tw0 negative-impact events (gl0bal financial crisis and dr0ught) was
met by an 0pp0site resp0nse – a 3.3% increase in the level 0f expenditure during 2009 and
2010 versus a marginal increase in 2015 and a significant decline during 2016. (Chart
1). The 0bvi0us questi0n, theref0re, is – why did the g0vernment behave differently under
similar circumstances, i.e., situati0ns where the c0untry was faced with a seri0us distress
situati0n?

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 Chart 1

Why does the government cut spending? Does the government spend not help?
The questi0n, theref0re, is why w0uld a g0vernment, in a largely agriculture dependent
c0untry, reduce its spend 0r n0t increase it sufficiently even during 0r after a dr0ught year?
The ch0ice 0f reducti0n in expenditure after tw0 c0nsecutive years 0f dr0ught during 2014
and 2015 is even m0re intriguing!!! S0me ec0n0mists/analysts have been making an
argument that India has transiti0ned fr0m being an agriculture dependent ec0n0my and
theref0re it can gr0w with0ut agriculture being supp0rted by the g0vernment. Let us l00k at
the validity 0f that argument by estimating the c0rrelati0n between gr0wth in agricultural
GDP and the aggregate GDP, b0th at current basic prices (Chart 2). We w0uld argue that the
c0rrelati0n level 0f 0.6596 is sufficiently high t0 deserve further investigati0n t0 determine
the impact 0f investment in agriculture 0n ec0n0mic gr0wth and the g0vernment’s r0le in this
investment, particularly during the dr0ught years.
Chart 2

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An argument for cutting back on government expenditure, often put forth by the believers of
‘minimum government’ premise, is the fear of inflation following or in anticipation of high
fiscal deficit (or expenditure gap). Let us now examine if there is indeed a strong case for
worrying about inflation.”

Does the government spend or deficit cause inflation?

“As a first step, we review the relationship between inflation and growth in government
expenditure. Chart 3 below estimates the correlation to be relatively weak at 0.2264, which
increases to 0.2836, if we exclude an exceptional year like 2016 – exceptional in the sense
that the growth in government expenditure was negative at -0.1% and the inflation was at
5.6%. We also evaluate the relationship between expenditure gap or deficit (Receipts –
Expenditure) and inflation to see if the level of deficit has much to do with inflation. Chart
4 below does not suggest that either. In fact, we observe that in many years, the inflation rate
has been low even when the deficit rates are high, e.g., 2000 to 2004. Also, we have years
when deficit is declining but inflation is increasing, e.g., 2004 to 2009. Similarly, Chart
5 below also suggests that the relationship between the level of deficit and inflation is at best
moderate – a correlation of 0.182”.
Chart 3

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 Chart 4

Chart 5

Does government expenditure contribute to economic growth?

“While we will discuss this issue in greater detail once we start working on resource
allocation choices and their impact on economic growth, the aggregate analysis does suggest
a relatively higher correlation between government expenditure and economic growth (Chart
6). It does not come as a surprise, as the government expenditure has been about 29% of GDP
for the last two decades and the government is the single biggest spender in the economy. If
we exclude a couple of exceptional years from our analysis, the relationship between
government expenditure and growth strengthens even further.
In other words, the government expenditure does have a positive impact in driving growth in
economic activity. We see the government playing an even more important role in enhancing

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the country’s ability to take risk and deal with uncertainty. It has no reason to shy away, as
the impact of higher expenditure or deficit on inflation is at best tenuous.”
Chart 6

What causes inflation, if the government deficits don’t?

“Given the stage of development, India is expected to have higher inflation. During the last
two decades, it has been in double digits for 5 years (of the 20-year study period) and above
the average rate of 7.1% for 3 years, making it 8 years of higher than average
inflation (Chart 7). It may be noted that 5 of these 8 years (of above average inflation) have
been between 2009 and 2014.”
“It may be pointed out here that the first decade of this century was characterised by
exceptionally high commodity prices, including that of crude. Chart 8 below provides
information about global commodity prices since 1995. Exceptionally high inflation is not
really deficit led but is probably caused by unprecedented increase in global commodity
prices. Commodity price inflation continued even after the global financial crisis – crisis that
had led to a near collapse of demand for commodities and that of economic activity itself.
That is, we were living in a world where the growth rates were slowing down (or
collapsing) but the commodity prices were going up. Commodities prices did collapse
during 2008 but came back with a vengeance post that.”
Another factor that impacts inflation and/or volatility in prices is the currency prices,
particularly so in an economy that runs a large trade or current account deficit unless, of
course, it has a large capital surplus (i.e., the country is an attractive investment destination).
India runs very large trade deficit and a higher current account deficit in most years and has
been an attractive destination in some years. Chart 9 below provides information about
variation in exchange rates India and its relationship with inflation. And, it is not surprising to

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find a positive correlation between variation of in exchange rates and inflation as India has
been becoming increasingly dependent on imports for feeding its consumption and
investment growth.
Chart 7

Chart 8

Chart 9

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What caused the spike and peaking of Government Expenditure during 2009 and 2010?
The 0bvi0us explanati0n lies in spiking 0f c0mm0dity prices, gl0bal financial crisis and the
dr0ught. The gl0bal c0mm0dity prices increased by 43.3% and 24.2% during 2009 and 2010,
respectively. The rain-deficit was at 21.8%, 0ne 0f the w0rst rain-deficits in independent
India. The g0vernment resp0nded by rising its spends by 0ver 20% f0r each 0f the tw0 years.
It n0t 0nly increased the devel0pment expenditure, it als0 increased the subsidies 0n
petr0leum and f00d pr0ducts – nearly d0ubling them fr0m INR 709.26 billi0n (1.42% 0f
GDP) in 2008 t0 INR 1,413.51 billi0n (2.18% 0f GDP) during 2010 (Chart 10). An0ther
fact0r that added c0mplexity was the surge in g0ld prices and the quantity 0f g0ld imp0rts,
putting pressure 0n exchange rate and resulting in speculative investment in an unpr 0ductive
asset – all 0f that in a l0w middle-inc0me c0untry that needs large investment in basic
infrastructure and has a large p0pulati0n 0f the p00r (Chart 11). Subsidies as well as the g0ld
imp0rts have c0me d0wn since then but c0ntinue t0 be high.
In additi0n, the g0vernment pr0vided b0th direct and indirect tax c0ncessi0ns t0 business and
individuals f0r supp0rting gr0wth. The gr0ss tax revenue peaked during 2008 at 11.52% 0f
GDP. It is n0t yet back at the same level. Reducti 0n in tax rates has n0t br0ught back gr0wth
either. It may have helped save the ec 0n0my fr0m c0llapse during the crisis peri0d, th0ugh!!!
W0uld we kn0w f0r certain? Pr0bably n0t, unless we investigate the relati 0nship between
reducti0n in tax rates and c0nsumpti0n and investment decisi0ns in the ec0n0my! Such an
investigati0n will require us t0 estimate the level 0f ec0n0mic activity with0ut and with these
c0ncessi0ns – n0t an easy task.

Chart 10

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Chart 11

Chart 12

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In short, the circumstances and the choice of policy resulted in a situation where the
government lost its ability to invest on a sustained basis9.

“While we still don’t have information for central as well as the state governments for the
year 2017, but we do know that inflation is low, deficits are also at a low level, oil prices
have fallen (though they have begun going up), gold imports are lower than in the past, rupee
is stronger (though it is getting weaker by the week at present), oil subsidy is down. Growth,
however, is yet to return to the earlier levels.”

CONCLUSION

9
Ibid.

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This project is all about the impact of public expenditure on inflation and deflation as we
know that public expenditure means the expenditure done by government on the public
infrastructural development so in this research paper work I have explained how this public
expenditure increases the price of commodity along with this I have also explained the impact
of public expenditures on inflation and deflation through graphs and charts. Government
spending means inflow of money in the market and as money inflow increases the price of
commodity increases.

This research paper helps me to understand about different concept related to public
expenditures and also helps me to learn how this government spending on development
projects fluctuates inflation and deflation of different commodity. So, this helps me to learn
allot.

BIBLIOGRAPHY

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Articles-

1. The Impact of Government Spending on Inflation through the Inflationary

Environment, STR approach by Mohsen Mehrara.
2. The Effect of Government Expenditures on Economic Growth by Lorena Dashamir
Cakerri
3. Public Expenditure and Trade Depression by R. G. Hawtrey.
4. Why Is Deflation Bad for the Economy? By somer Anderson.

Online resources-

1. www.jstor.com
2. www.heinonline.com
3. www.investopedia.com

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