How does expansion of government expenditures affect inflation: an analysis of the US economy

In June 2023, IMF staff completed a visit to Kazakhstan and published a press release containing conclusions about the country's current economic situation. It notes that in the revised state budget for 2023, the expansion of budgetary expenditures is significant. “With the economy already showing strong growth in the first months of the year, additional stimulus risks delaying fiscal consolidation and undermining efforts to curb inflation,” the study said. High growth rates of government spending, coupled with increased transfers from the National Fund, are undermining the recently introduced fiscal rules, having a negative impact on the credibility of the government's medium-term budgetary commitments.

It is noted that at the moment in Kazakhstan there is a gradual decrease in the annual rate of price growth, but mainly against the backdrop of last year’s high base, a decrease in world food prices and the strengthening of the national currency due to an increase in the base rate. Against this backdrop, the IMF noted that monetary policy should be tightened in 2023 until inflation declines sustainably and inflation expectations are re-anchored. The IMF positively assessed the efforts of the National Bank (NB RK) to improve communication about monetary policy decisions. At the same time, the IMF notes that further efforts are needed to strengthen the authority and independence of NB RK. The IMF supports plans to completely eliminate the subsidized lending programs of NB RK by the beginning of 2024.

Considering the decision of NB RK to reduce the base interest rate by 25 basis points on August 28, 2023, the IMF’s recommendations take on special significance. AERC has repeatedly noted in the monthly inflation forecast the risks of premature easing of monetary policy.

However, the question raised by the IMF about the impact of fiscal expansion - increasing government spending - on inflation is less clear-cut. Is it true that an increase in government spending can lead to an uncontrollable rise in prices in the country? If it is true, there is another question which is under what conditions does this happen? In this regard, it is interesting to turn to a relatively recent study (Jørgensen et. al, 2022).

The authors study the impact of government spending shocks on prices in the US economy. And here is an important point: the main conclusion of the study is that prices in the US economy do not rise in response to fiscal expansion. Instead, the price reaction is usually negative, although often not statistically significant. This mysterious price response is accompanied by an increase in production and private consumption, as well as an increase in total factor productivity. But one should not immediately rush to the opposite point of view, that government spending does not affect inflation at all. It is worth referring to the authors' explanations of the results obtained.

Thus, the authors provide an explanation for this based on the model they developed, which includes the time-varying introduction of new technologies (equipment) into the production process. In this model, firms decide to what extent they use the available level of technology (equipment). The authors assume in their modeling that, in response to increased government spending, firms find it optimal to increase technology (equipment) utilization rates to meet the growth in aggregate demand, despite the costs associated with higher utilization rates. Increasing the use of technology (equipment) increases measured productivity, which is consistent with empirical evidence. Provided this mechanism is strong enough, it dominates and exerts the pressure on marginal costs due to higher wages, resulting in lower marginal costs in equilibrium. Lower marginal costs open the door for companies to lower prices, thereby causing lower inflation. In response, the central bank lowers the nominal interest rate, which ultimately causes the real interest rate to fall. This, in turn, contributes to increased consumption.

In other words, the results of a study in the United States show that government spending may not affect inflation growth only if public funds “injected” into the economy result in high-quality technological progress of companies.

Let us repeat that the authors of the study say that government spending may not affect inflation if these funds lead to the technological process of domestic production in the country (domestic companies). As for Kazakhstan, the study by NB RK “The Impact of Government Expenditures on the Current Account of the Balance of Payments of Kazakhstan through the Channel of Imports of Goods” shows that government expenditures in Kazakhstan are sponsored, for the most part, by imports from abroad. As a result, inflation imports from abroad increase. Thus, an increase in budget expenditures excluding debt servicing costs in Kazakhstan by 1% in the current month leads to an increase in imports excluding imports of oil companies by 0.6% in the next month, followed by a complete attenuation of the impulse after 5 months.

As for whether the increase in government spending leads to technological progress of domestic firms, statistics do not give a clear answer. Official macroeconomic statistics do not record the utilization rate of technology or equipment, nor do they provide indicators by which they could be calculated.

However, it seems possible to indirectly assess the degree of connection between the situation in Kazakhstan and the conclusions that the authors obtained, based on essentially similar indicators. Thus, the coefficient of renewal of fixed assets shows what part of the fixed assets available at the end of the reporting period is made up of new assets. Table 1 shows data on this indicator for Kazakhstan and the USA.

Table 1.

Source: BNS RK and BEA

Based on the data, it can be noted that the coefficient of renewal of fixed assets in Kazakhstan over the past 8 years has tended to decline, while in the USA it has been constantly increasing. Next, we will determine whether there is any connection between the conclusions obtained in the article and the nature of the changes in the mentioned indicators.

Table 2.

Source: calculated based on data from the BNS RK and the Ministry of Finance of RK

From Table 2 we can conclude that in Kazakhstan there is no clear, direct connection between the expansion of budget expenditures and the growth of the renewal ratio. It is worth noting that the reasons for high inflation rates in Kazakhstan are more global. At the same time, internal factors increasing price growth are largely associated with weak macroeconomic discipline, regulatory and country risks, that is, both the demand side and the supply side have an impact. Thus, the conclusions from this article obtained for the US economy cannot be applied to the economy of Kazakhstan, which is confirmed by statistical data. It is clear that the conclusions for the United States - a large open economy - cannot be suitable for a small open economy (including resource-based economy) like Kazakhstan. In addition, it is worth noting that even in the United States there is no uniform assessment of the impact of government spending on inflation.

For example, in another study (Chang Liu, Yinxi Xie, 2023), guided by the theoretically implied Phillips curve with government spending, the authors estimate it using aggregate data for the United States, including inflation, inflation expectations, unemployment rate and government spending. The estimation results show that changes in government spending explain a significant part of the changes in inflation rates.

The effect of government spending on inflation depends on many parameters and is therefore not necessarily positive. Thus, the backlash of inflation and inflation expectations challenges the conventional wisdom that inflation and inflation expectations should rise along with fiscal spending. From a supply-side perspective, inflation falls as a result of increased government spending. This effect is relatively permanent and lasts about one and a half years. Taken together, the study's findings highlight the importance of the often overlooked supply channel through which inflation responds to fiscal expansion.

Thus, it should be recognized that an increase in government spending does not always lead to an increase in inflation. In practice, there are some exceptions, which, however, do not work in the economy of Kazakhstan. In Kazakhstan, there is no relationship between government spending and technology, from which it cannot be concluded that the state stimulates the development of technology. Moreover, at this stage, government spending stimulates imports, which causes inflation to import into Kazakhstan from abroad. Of course, not all economies see increased government spending leading to increased inflation. However, Kazakhstan is not one of these countries. At the moment, there is no budget discipline in the country, which the IMF has repeatedly noted in its studies. Given the sufficient contribution of government spending to inflation, in order to reduce this impact, government spending must be productive. That is, they should stimulate not aggregate demand, but aggregate supply. In such conditions, the use of incentive mechanisms that are used in the Kazakh economy at the present stage (preferential car loans/mortgage loans) can no longer be considered effective in terms of curbing inflation rates. In current realities, the most appropriate would be the introduction of lending to “complex” and/or innovative technologies.