Estimating the relationship between government spending and private consumption in Sri Lanka

Abstract

Introduction

In general, government plays a vital role in the development process and contributes to ensure the social welfare of a country. In order to achieve a country‘s macroeconomic goals, the government intervenes in the economy in particular through fiscal policy. Government spending is a key component of fiscal policy which can be used to stabilize the economy over the course of the business cycle. Impacts of government spending on aggregate economic activity have been subject to vast discussion under different schools of thought. According to Keynes‘s Absolute Income Hypothesis, households‘ current consumption responds to current disposable income; thus an increase government spending leads to increase in output and employment (Athukorala and Karunarathna, 2004; Khan et al., 2015). In contrast, under neoclassical theory and New Keynesian theories, expansion of government spending will crowd-out private consumption through negative wealth effect dominance (Agibaeva, 2015).

In the Sri Lankan context, although the government plays an important role in the economy, lack of fiscal discipline appears as one of the hurdles in accelerating economic growth due to a mismatch between government spending and revenue. Government expenditure, which consists of recurrent and capital expenditure shows an increasing trend while recurrent expenditure grew rapidly compared to the capital expenditure.. However, the government expects to stimulate economic activity with the help of engaging in a large range of government spending. Meanwhile, economic growth shows a decreasing trend in recent years. Since private consumption is a major component of aggregate demand, it is important to find ways to boost private consumption for smoothening of economic performance especially when there is a weak growth.

Since the relationship between government spending and private consumption is a major concern of current academic discourse, a large number of empirical studies has focused on it and present mixed results. Khan et al. (2015) found government spending to have a positive impact on private consumption implying that government spending is a very good instrument to boost the economy. Similarly, an increase in government purchases leads to an increase in output and private consumption. The increase in labor remuneration induces households to sacrifice leisure in favor of consumption (Ravn et. al, 2007). Moreover, government spending increases or crowds-in private consumption following a spending shock because of the multiplier effect (Blanchard & Perotti, 2002; Athukorala and Karunarathna, 2004). This positive effect is also justified by the empirical studies of Ganelli & Tervala (2009) & Ihori (1990). In contrast, according to a study of OECD countries conducted by Ho (2001), the permanent income hypothesis is rejected and the crowding-out effect of government spending is supported. Moreover, there is substitutability between government spending and private consumption in the US economy (Kormendi, 1983).

Thus, findings of empirical studies contribute to broadening the existing knowledge on government spending and private investment in different scenarios. However, in the Sri Lankan context, research on government spending and private consumption is inadequate to trace the effects and contribute towards poliy formulation. Meanwhile, economic growth in Sri Lanka is required to accelerate, especially through inducing greater aggregate demand since the growth rate has slowed down. Hence, considering the current importance, this study attempts to fill the existing knowledge gap by investigating the nexus between government spending and private consumption in Sri Lanka.