Government Spending Effects in Low-income Countries
IMF Working Papers, December 30, 2015
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Bibliographic details
- Authors: Wenyi Shen, Susan S. Yang, Luis-Felipe Zanna
- Published: December 30, 2015
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781513578972.001
Summary
- Despite the voluminous literature on fiscal policy, very few papers focus on low-income countries (LICs). This paper develops a new-Keynesian small open economy model to show, analytically and through simulations, that some of the prevalent features of LICs—different types of financing including aid, the marginal efficiency of public investment, and the degree of home bias—play a key role in determining the effects of fiscal policy and related multipliers in these countries.
- External financing like aid increases the resource envelope of the economy, mitigating the private sector crowding out effects of government spending and pushing up the output multiplier.
- The same external financing, however, tends to appreciate the real exchange rate and as a result, traded output can respond quite negatively, reducing the overall output multiplier.
- Although capital scarcity implies high returns to public capital in LICs, declines in public investment efficiency can substantially dampen the output multiplier.
- Since LICs often import substantial amounts of goods, public investment may not be as effective in stimulating domestic production in the short run.
Key Findings and Mechanisms
- External financing (aid) effects:
- Increases the resource envelope of the economy.
- Mitigates private sector crowding out from government spending.
- Raises the output multiplier.
- Tends to appreciate the real exchange rate, which can cause traded output to respond quite negatively and reduce the overall output multiplier.
- Public investment efficiency:
- Capital scarcity in LICs implies high returns to public capital.
- Declines in public investment efficiency can substantially dampen the output multiplier.
- Trade and import composition:
- High import content of public investment in LICs limits short-run effectiveness of public investment in stimulating domestic production.
Model and Analysis
- Framework: new-Keynesian small open economy model.
- Methods: analytical derivations and simulations used to assess the role of:
- Types of financing including aid,
- Marginal efficiency of public investment,
- Degree of home bias,
in determining fiscal policy effects and multipliers in LICs.
Policy Implications
- Aid and external financing can enhance fiscal multipliers by expanding resources and reducing crowding out, but policymakers should account for potential exchange rate appreciation and adverse effects on traded output.
- Improving public investment efficiency is critical; inefficiencies can substantially reduce the effectiveness of public spending in raising output.
- Given substantial import content in LIC public investment, complementary policies to strengthen domestic supply and local content may be necessary to boost short-run domestic production responses.