1. General government purchase of goods and services

More government purchase increases the demand for private output. Consequently, private-sector employment rises in the short run. In the long run, there is no effect on private-sector employment.

 

hmtoggle_arrow1A. An increase in general government spending

 

In the following, the public expenditure is increased permanently by 0.1 percent of GDP relative to the baseline in 2010 prices.(See experiment)

 

Table 1a. The effect of a permanent increase in general government spending

    1. yr 2. yr 3. yr 4. yr 5. yr 10. yr 15. yr 20. yr 25. yr 30. yr
    Million 2010-Dkr.
Priv. consumption fCp 54 340 477 528 547 612 799 993 1115 1179
Pub. consumption fCo 1748 1785 1815 1845 1875 2031 2195 2371 2558 2759
Investment fI 598 895 711 575 499 233 167 212 252 265
Export fE -65 -135 -228 -342 -475 -1291 -2016 -2457 -2662 -2749
Import fM 843 1066 1006 951 922 783 722 729 763 816
GDP fY 1498 1828 1783 1673 1549 862 512 496 617 762
    1000 Persons
Employment Q 1.09 1.61 1.77 1.78 1.71 0.75 -0.02 -0.28 -0.26 -0.16
Unemployment Ul -0.59 -0.83 -0.90 -0.90 -0.85 -0.37 0.01 0.14 0.13 0.08
    Percent of GDP
Pub. budget balance Tfn_o/Y -0.06 -0.05 -0.05 -0.05 -0.06 -0.10 -0.13 -0.15 -0.16 -0.17
Priv. saving surplus Tfn_hc/Y 0.01 -0.02 -0.02 -0.02 -0.02 0.00 0.01 0.00 0.00 0.00
Balance of payments Enl/Y -0.05 -0.07 -0.07 -0.07 -0.07 -0.09 -0.12 -0.14 -0.16 -0.18
Foreign receivables Wnnb_e/Y -0.10 -0.20 -0.28 -0.35 -0.42 -0.79 -1.20 -1.65 -2.12 -2.59
Bond debt Wbd_os_z/Y 0.03 0.07 0.10 0.14 0.19 0.49 0.91 1.36 1.80 2.23
    Percent
Capital intensity fKn/fX -0.11 -0.11 -0.10 -0.09 -0.07 -0.02 0.00 0.01 0.01 0.00
Labour intensity hq/fX -0.08 -0.08 -0.06 -0.06 -0.05 -0.04 -0.05 -0.05 -0.05 -0.05
User cost uim 0.00 0.01 0.02 0.04 0.05 0.10 0.13 0.13 0.13 0.12
Wage lna 0.01 0.04 0.07 0.10 0.13 0.24 0.28 0.26 0.24 0.22
Consumption price pcp 0.00 0.01 0.02 0.03 0.05 0.10 0.13 0.13 0.13 0.12
Terms of trade bpe 0.00 0.01 0.02 0.02 0.03 0.06 0.07 0.07 0.07 0.06
    Percentage-point
Consumption ratio bcp -0.04 -0.02 -0.01 0.00 0.00 0.00 0.00 0.01 0.02 0.02
Wage share byw -0.02 -0.01 0.01 0.02 0.03 0.05 0.05 0.03 0.02 0.02

(See details)

 

The immediate effect of an increase in government purchase of goods and services is that total demand rises. The increased demand is met partly through domestic production and partly through imports. The expansion in domestic economic activity raises private sector employment and lowers unemployment. The lower unemployment rate pushes prices and wages upward and reduces competitiveness. The lower competitiveness makes the market share of exports fall and the market share of imports rise, which reduces the positive effect on domestic production. Eventually, the effect on employment disappears and employment returns to its baseline. The long run effect on unemployment is also zero reflecting that the permanent increase in wages and prices deteriorates competitiveness and crowds out any impact on employment. This is the wage-driven crowding out process in ADAM.

 

The short run effect is closely related with the Keynesian income multiplier. The income multiplier refers to the final change in income as compared to the injection of capital deposits or investments which originally fueled the growth. It is usually used as a measurement of the effects of government spending on income. In the present experiment, the income multiplier can be seen as the ratio between the effects on final demand and the change in government purchase of goods and services. In a closed economy, the multiplier for domestic demand is larger than one because the exogenous increase in government purchase of goods and services creates additional domestic demand in the form of more private investment and larger private consumption. However, the ADAM multiplier for GDP remains less than one because higher demand triggers not only GDP but also imports, see ADAM book for further discussion.

 

Wages and domestic prices increase in the medium and long run. But not equally. Prices adjust gradually to total production costs, which includes more than wages. Imported goods and services are for instance part of production costs. As the prices of imported goods are unchanged, prices increase less than wages. This results in a permanent positive effect on real wages, real income and private consumption. The long-term macro-consumption function in ADAM relates consumption to income and wealth and ensures that private consumption, real income and real wealth attain the same growth rate in the long run. Whenever real wages and real disposable income change permanently, private consumption changes, henceforth referred as a real wage effect.

 

The real wage effect also translates into a long-run effect on the terms of trade. In the new equilibrium employment returns to its baseline while wages and prices increase permanently, which results in a permanent change in the long-run terms of trade.

 

The composition of GDP changes permanently towards higher public and private consumption and lower net exports relative to the baseline. That is, the composition of aggregate demand shifts from exports toward domestic consumption and investment and the composition of aggregate supply shifts from domestic production to imports.

 

The experiment also creates a permanent change in the distribution of income. There is a permanent increase in the wage share defined as the share of value added which is payed out to workers. This is because wages have increased permanently higher than capital costs or more appropriately user costs. The effect on user costs is smaller because interest rates are fixed and investment prices change less than wages.

 

Figure 1a. The effect of a permanent increase in general government spending

 

fig_1_1a_zoom38fig_1_2a_zoom38

 

 

fig_1_3a_zoom38fig_1_4a_zoom38

 

 

fig_1_5a_zoom38fig_1_6a_zoom38

 

 

fig_1_7a_zoom38fig_1_8a_zoom38

 

The experiments here and below demonstrate that the public budget could end up either in deficit or in surplus depending on the effect on public revenues or expenditures. Above the government budget balance and the balance of payments become negative in the long run. On the contrary the consumption equation stabilises the saving surplus of the private sector in the long run. Thus the private sector saving surplus returns to its baseline. If the higher public consumptions are financed by higher income taxes, there would be no permanent negative effect on the public budget. This affects long run effects on private and foreign demand.

 

 

hmtoggle_arrow1B. An increase in general government spending - balanced budget

 

Table 1b presents the effect of a permanent increase in government purchases of goods, financed by higher income taxes. The public purchase of goods and services is increased by 0.1 percent of GDP, in 2010 prices. The central government income tax rates are permanently raised by 1.5 percent and the capital tax is temporarily raised by a lump sum of 0.4 percent of GDP in the first year only. (See experiment)

 

Table 1b. The effect of a permanent increase in public spending, balanced budget

    1. yr 2. yr 3. yr 4. yr 5. yr 10. yr 15. yr 20. yr 25. yr 30. yr
    Million 2010-Dkr.
Priv. consumption fCp -610 -912 -1232 -1529 -1773 -2348 -2507 -2656 -2833 -3016
Pub. consumption fCo 1748 1785 1815 1845 1875 2032 2197 2373 2561 2763
Investment fI 277 180 -267 -554 -711 -794 -506 -334 -302 -319
Export fE -38 -58 -78 -97 -110 -35 182 305 255 105
Import fM 459 342 61 -124 -229 -288 -101 25 62 53
GDP fY 914 651 176 -210 -487 -857 -541 -351 -393 -531
    1000 Persons
Employment Q 0.71 0.73 0.46 0.16 -0.10 -0.56 -0.13 0.23 0.27 0.15
Unemployment Ul -0.38 -0.37 -0.22 -0.07 0.06 0.28 0.06 -0.12 -0.14 -0.08
    Percent of GDP
Pub. budget balance Tfn_o/Y 0.03 0.03 0.02 0.00 -0.01 -0.03 -0.01 0.00 0.01 0.01
Priv. saving surplus Tfn_hc/Y -0.06 -0.06 -0.02 0.00 0.02 0.04 0.02 0.01 0.01 0.00
Balance of payments Enl/Y -0.03 -0.02 -0.01 0.00 0.01 0.02 0.01 0.01 0.01 0.01
Foreign receivables Wnnb_e/Y -0.06 -0.08 -0.07 -0.05 -0.02 0.10 0.16 0.18 0.20 0.21
Bond debt Wbd_os_z/Y -0.05 -0.07 -0.08 -0.07 -0.06 0.06 0.12 0.10 0.06 0.02
    Percent
Capital intensity fKn/fX -0.09 -0.07 -0.05 -0.04 -0.04 -0.08 -0.12 -0.14 -0.14 -0.14
Labour intensity hq/fX -0.07 -0.05 -0.04 -0.03 -0.03 -0.03 -0.03 -0.03 -0.03 -0.03
User cost uim 0.00 0.01 0.01 0.02 0.02 0.02 0.01 0.01 0.02 0.03
Wage lna 0.01 0.02 0.03 0.04 0.04 -0.01 -0.04 -0.03 -0.01 0.01
Consumption price pcp 0.00 0.01 0.01 0.01 0.01 -0.01 -0.03 -0.03 -0.02 -0.01
Terms of trade bpe 0.00 0.00 0.01 0.01 0.01 0.00 -0.01 -0.01 -0.01 0.00
    Percentage-point
Consumption ratio bcp 0.03 0.02 0.01 -0.01 -0.02 -0.05 -0.05 -0.04 -0.04 -0.04
Wage share byw -0.01 0.00 0.01 0.02 0.02 0.00 0.00 0.01 0.02 0.02

(See details)

 

In contrast to the unfinanced experiment in section 1, the long-term effect on government debt is now zero. There are two opposing effects - expansionary and contractionary effects. The former is due to the increase in public expenditures that increases domestic demand, production and employment. The contractionary effect is due to the increase in income tax rates which reduces disposable income and there by private consumption. In the very short term the expansionary effects are stronger so production and employment expand. Investments also expand reflecting the increase in business investments in machinery and buildings.

 

The overall positive effect in year 1 occurs because private consumption reacts to the tax increase with a delay. In the following year, the tax increase reduces consumption further as disposable income falls. As a result, employment falls. With a financed public purchase, it takes only 4 years for the improved budget to disappear and it takes almost the same number of years for employment to return to the baseline. The fall in private consumption reduces the demand for housing, and investment in housing and house prices fall. In the long run, private consumption and investment fall due to the permanent fall in disposable income. Investments also fall permanently due to the fall in residential investment.

 

The effect on unemployment oscillates before reaching equilibrium reflecting the fluctuation in the housing market and labor market. In general, with an unfinanced increase in public purchase it is exports that fall and make room for the public purchase of goods and services. With a tax-financed public purchase increase, it is the private domestic demand that falls to make room for the public purchase of goods and services. The public budget can be financed in various ways, and the outcome depends on the choice of financing instrument. For example, the outcome of the unfinanced shock in section 1a is equivalent to the outcome of an increase in public purchase financed by reduced public transfers to abroad. Public transfer vis-a-vis the foreign sector has no impact on the private sector in ADAM.

 

Figure 1b. The effect of a permanent increase in public spending, balanced budget

 

fig_1_1b_zoom38fig_1_2b_zoom38

 

 

fig_1_3b_zoom38fig_1_4b_zoom38

 

 

fig_1_5b_zoom38fig_1_6b_zoom38

 

 

fig_1_7b_zoom38fig_1_8b_zoom38