Government’s economic decision has several implications manifested in the form of changes in various macroeconomic variables. Economists have asserted that one of such effects is seen on economic decision of private sector. The use of various policy instruments by the government to influence the economic behavior of the private sector is fairly a non-debated issue. However, the functional relationship between public and private economic activities, whether the previous one complements the latter or they depict substitutable relationship has left many economists divided among them.
Two sides of the coin
Negative effect of private investment through reduced productivity of capital: Economists from neo-classical tradition considered private individuals as rational economic agents always aiming to make optimal economic decision. In that sense, given the declining marginal productivity of capital (productivity of additional unit of capital stock), private investors, other things remaining the same, make investment up and until the cost of additional unit of investment is equal to the benefits accrued through that particular unit of investment. An increase in government investment leads to the distortion of the optimal level of capital stock, causing the private investors to cut back their investment to bring the level of capital stock to the previous optimal level, thus causing the ex-ante crowding out of private investment. In other words, when government increases its investment, the cost of capital becomes higher that the benefit or the productivity leading private investors to reduce their investments.
Increased productivity of private capital through public investment in infrastructure: On the flip side, increase in government’s infrastructure investment increases the productivity of private capital inducing the private sector to upscale their investment. Government investment in infrastructures like roads, electricity and telecommunications leads to better utilization of private capital resulting higher benefits and reduced costs. Hence, there are greater incentives for private investors to increase their investment.
Effect on market interest rate
Financing government expenditure through issuance of debt instruments increases the total demand of the investable funds or saving in the economy. An increase demand for the investable funds puts upward pressure on interest rate, making the borrowing and thus investment costly to the private businesses. Rise in interest rate due to rise in government expenditure financed through borrowing, thus subsequently causes a reduction in private investments.
However, government’s effective investment plans can create employment and can lead to rise in national income, consequently pushing national savings which would put downward pressure on market interest rate. But, the resultant reduction in interest rate depends upon the ratio of increase in national income to increase in government investment. Higher the ratio of change in national income to change in government investment, higher is the pressure on interest rate to decline.
Relation in the context of Nepal
Impact of government expenditure—be consumption or investment expenditure—on private investment in Nepal has been least researched. We cannot even find a handful of research works and articles on this particular issue. Therefore, it is extremely difficult to know whether government expenditure has any positive or negative impact on private investment and through what mechanism.
A recently conducted research conducted which has considered data for 40 years from 1975 to 2013 has shown that public investment has negative effect on private investment in the long run. It shows that a 100 percent increase in public investment leads to reduction of private investment by 47%. On the other hand, public consumption has positive and significant impact on private investment. 100 percent increase in real public consumption expenditure leads to increase in private investment by 132 percent.
The reason why public consumption has positive impact on private investment may be that the private sector is increasing its investment in order to meet added government consumption demand. Whereas, the negative effect of public investment on private investment, as mentioned above might have caused due to reduced marginal productivity of capital as a result of increased government investment or rise in government investment expenditure might have put upward pressure on market interest rate, making private investment costly.
However, as this particular issue lacks substantial studies and requires further research, the particular research which I have adhered to should only be taken as an indicative one. The government should make proper analysis of impact of public expenditure, both consumption and investment on investments from private sector. The government expenditure should not be such that it crowds out private investments.
– This article was originally publised by Ashesh Shrestha in The Himalayan Times on February 23, 2020.