Fiscal Policy, Fiscal Multipliers, Debts, Deficits and Economic Development

There is disquiet by some persons about Ghana’s debts, deficits and by extension fiscal policy. Some have even gone a step further to suggest that Ghana will soon become Highly Indebted Poor Country (HIPC) again. This article will attempt to explain the dynamics of Ghana’s fiscal policy, debt, deficits and how this links to Ghana’s economic development.

Fiscal policy refers to government expenditure and taxation policies. When a government wants to carry out fiscal policy, the options available to the government is either to increase/decrease expenditure or increase/decrease taxes or a combination of expenditure and tax increment and decrement. Government debt refers to the historical sum of amounts owed to both domestic and international lenders while the deficit refers to the difference between revenue and expenditure. If government revenue is higher than expenditure then the government will run a surplus. If, however revenue is less than expenditure then government will run a deficit.

Debt is not bad in principle. What makes debt bad is what it is used for. For example, if a government borrows $600,000 to spend on a fence wall for a government building, then this debt is most likely not going to be repaid as it is not going to generate any revenue. Similarly, if a government borrows $72 million to spend on software then by all means this debt is not going to be repaid as it will generate no revenue for government kitty. I have used the software and fence wall examples because in all probability, a fence wall does not cost $600,000 dollars to build and a software (enterprise) does not cost $72 million. Thus, these expenditures will not generate $600,000 and $72 million worth of economic activity.

When government spends a certain amount of money let’s say, GH₵ 1 billion and assuming that demand equals supply such that this extra expenditure does not lead to an increase in the price level, this leads to the production of an extra GH₵ 1 billion worth of goods and services. This implies that changes in aggregate demand leads to a corresponding change in aggregate output as measured by real gross domestic product.

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Assuming the government of Ghana decides to spend GH₵ 135 billion on affordable home construction over the next 8 years, aggregate income and aggregate output will increase by the same value (bearing in mind the assumption of demand equaling supply) as every cedi spent translates to a cedi of income for construction workers, electricians, surveyor’s suppliers of building materials etc. If the process stopped at this stage, it will mean that the GH₵ 135 billion investment leads to exactly GH₵ 135 billion increases in income. But the process does not stop there as the increase in income flows to households in the form of profits and wages. The increase in wages leads to higher consumer spending which in turn leads to an increase in aggregate demand causing firms to produce more thereby generating another round of additions to aggregate income.

Marginal propensity to consume (MPC) will enable us to determine the overall effect of a GH₵ 135 billion investments. Specifically, the MPC refers to the percentage of an individual or national income that is consumed thus if aggregate income increases by GH₵ 10 billion and consumer spending increases by GH₵ 6 billion then marginal propensity to consume is 0.6 (MPC is always between 0 and 1).

From 1992 to 2016, Ghana’s MPC is 0.9 (from savings rate – Ghana Statistical Service data) therefore, after a hypothetical GH₵ 135 billion investment the total effect on Ghana’s economy is given as

  • Increase in investment spending = GH₵ 135 billion
  • 2nd round of investment spending = MPC x GH₵ 135 billion
  • 3rd round of investment spending = MPC2 x GH₵ 135 billion
  • 4th round of investment spending = MPC3 x GH₵ 135 billion

total increase is then given as (1 + MPC + MPC2 + MPC3 + ….. ) + GH₵ 135 billion

We know from mathematics that when we have an infinite series of the form (1 + x + x2 + x3 …) where x is between 0 and 1 as pertains above, it can be rewritten as 1/(1-x). This means that with an MPC of 0.9 and an estimated government expenditure between 2009 and 2016 of GH₵ 135 billion (i.e. $30 billion) total increase in Ghana’s gross domestic product between this period should be 1/(1-0.9) x GH₵ 135 billion = GH₵1.35 trillion.

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That said, it will interest the reader that the sum of Ghana’s real gross domestic product for 2009-2016 was GH₵ 240 billion instead. This implies that an estimated GH₵ 1 trillion worth of ‘potential’ income was lost between 2008 and 2016 for various reasons. It is not surprising that our public-sector debt shot up by almost 900% in this period. Looking at investment alone Ghana’s fiscal multiplier between 2009-2016 is 10 which is very high meaning that fiscal policy if well implemented will produce the desired economic outcome and improvement in the economic welfare of Ghanaians.

We have seen from the analyses that when government expenditure increases the economy grows but this economic growth happens only when it is used for value for money investments and utility generating economic activities. Despite the astronomical growth in government expenditure between 2009 and 2016 there was sharp decline in gross domestic product. The peak seen in 2010 is due to the production of crude oil in commercial quantities so controlling for that paints an even bleak picture of economic activity between 2009 and 2016.

It is good economics for Ghana to aim to reduce its debt to GDP ratio and this is important when one considers the fact that we do not borrow in Ghana Cedis on international markets. However, the current government met what can best be described as empty coffers therefore as long as government is determined to carry out the one district, one factory, free SHS and other economic policies and social interventions then debt to GDP ratio will rise marginally before it falls. Ghana will only return to HIPC – that is if Ghana is allowed to assess the debt relief program twice –  if government expenditure and the economy is managed like it was managed between 2009 and 2016. So far, the evidence suggests otherwise.

Notes: The assumption of aggregate demand equaling aggregate supply is realistic in the short run but in the long-run aggregate increment in expenditure is likely to have an impact on the price level.

 

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