Role of Private Investment on 'Literature Review' chapter

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  • Subject: Economics
  • Type: 'Literature Review' chapter
  • Paper: #672069

Excerpt from 'Literature Review' chapter :

This also implies inadequacies in fiscal sustainability, which influences investments in private sectors.

The second channel happens through the level, composition and quality involved within the public investment, which shows the level at which the public investment replaces the private investments (Schmidt- Hebbel, Serven, & Solimano, 1996).

The final channel regards the level of taxation on the corporate earnings and the rules applicable in depreciations.

There have been arguments that fiscal policy and public expenditure reduces the private investments in two different manners. These include increasing the interest rates or lowering the private funds involved in financing the investments.

According to the neoclassical theory, the interest rate is also an imperative variable in finding the level of investment. Consequently, it results into a negative effect because it upsurges the interest payable in investments. Concurrently, McKinnon and Shaw, contends that this is likely to cause a positive relationship between the investment and interest rate. This is possible because the interest rates have high chances of increasing the savings and this increases the volume of domestic credit, which forces the equilibrium investment to increase. This led to the formation of McKinnon-Shaw hypothesis, which believed that the quantity of fiscal resources has more impact on investment than the cost of fiscal resources (Khan & Khan, 2007;(Arvanitidis, Petrakos & Pavleas, 2007).

The public plays a significant role in the public investments among the developing countries. The public also have an impact on the private sectors by either causing a crowding in or crowding out. Keynesian approach believes that crowding out has a minor effect on both private and public sectors. For example, underemployment lowers the total demand in a state and this is likely to lower the level of production. During such circumstances, the government plays a significant role in ensuring that it increases the demand through lowering the rate of taxes while increasing the public expenditures. Consequently, this is likely to increase the demand as well as the private investments thus increasing the general investments. This is likely to increase the interest rate without any effect on the crowding out.

On the contrary, different research argue against the conclusion by claiming that availability of such policies in the state can enhance increment within the public infrastructure, which might be essential to private investments. This implies that improving the infrastructure is beneficial to the private sectors especially on their credit, which enhances their investments. On the contemporary, this implies that lack of good infrastructure in the developing countries affects the development within private sectors in a negative way. Consequently, this will affect the provision of goods and services such as social services, roads and power plants among others in such countries and these are essential services to the private sectors


(Abdelhadi, Areiqat & Altrawenh, 2011; Khan M, 1997; Khan & Reinhart, 1990; Majeed & Khan, 2008)

. Remarkably, this means that countries with enough and good public infrastructure are likely to benefit the private sectors in the region. Therefore, it is imperative for the public sectors to consider improving the infrastructures so that they can benefit the private sectors ( Chibber, Dailami&Shafik 199; (Hulten, 1996). Importantly, it should come to notification that restrictive fiscal policy plays the role of lowering the high fiscal deficits, which crowd out private sectors through increasing interest rates of lowering the existence of credits. It is therefore imperative for the fiscal adjustment to give private sectors chance for expansion. According to Van Wijnbergen (1982), and Matin&Wasow (1992), it is true because there were some similar outcomes in Korea and Kenya respectively, since there is a high relationship between increase in tax and decrease in expenditure. Additionally, it is possible that the decrease in fiscal deficit is likely to lower the private investment. This is a common issue in the developing countries because lowering the public investment has a negative impact on the private investment (Blejer & Khan, 1984; Greene & Villanueva 1991).Developing countries should also put in consideration that fiscal policy decreases the aggregate demand together with the expected output, which might end up affecting the private investment using accelerator principle.

The empirical studies conducted in different developing countries have been able to confirm the results. This is because the studies indicated that the government is very imperative in the economic activities of any given country. The research indicated that it is possible because the private sectors do not perform large investment projects in developing countries. The capital within the public sectors affects the private investments in two different ways, which include the fact that they compete for resources with each other and can have goods that compete in the market. In the economic literature, they refer to such situation as the crowding out. On the contrary, it is possible for the capital in the public sector to have a positive impact on the productivity, thus causing a positive externality, which is common in the investment of infrastructures. According to the economic literature, they refer to such positive impact as the crowding in ADDIN EN.CITE

(AGARWAL, 2009; Atukeren, 2005; Bouton & Mariusz, 2000)

Different studies have also indicated that tax system has an impact on investment (Pinell-Siles, 1979). This is because the study found out that shortages within the tax system occurring from inflation and taxable income has a negative impact on the investment within the affected country. Furthermore, the research revealed that both private and public investments have an impact of the development process of the given country. Therefore, this enables Khan and Reinhrt (1990) to apply the growth model in determining the benefits of both private and public investments. During their research, their major aim was analyse the adjustment policies in the market that plays a significant role in the improvements of private economic activities in developing countries. The researchers use an example of twenty-four Latin American and Asian countries to show the relationship between private and public investment. The results indicate that the productivity of public and private sectors differ where the private one is positive while the public one is negative. In justifying this, the researchers gave an example of IMF and the bank. They also claim that many researchers have ignored to conduct many studies on the impact of public investment on economic growth. They claim that in most countries, public investment play the role of offering public services such as health facilities and schools, which are vital in the improvement of private investment, and this supports growth.

Notably, different studies have indicated that fiscal policy has an ambiguous effect on investment in both the private and public sectors. The studies indicate that government spending that rely on any form of borrowing have high chances of replacing the private investment through increasing the interest rate or lowering the availability of credit in the private sectors. Additionally, the studies also indicate that the short-run effects of attractive fiscal environment on the private investment might be limited. The research also encouraged different countries to draw their attention on improving their infrastructures because lack adequate infrastructure in a country affects development within the private sectors thus affecting the economy of the involved countries. The government should also work hard towards reducing the tax rates while increasing the rate of public expenditures. This is imperative because it will increase the rate of productivity in private investment, which will increase the general investment in a country.

3.3.3 The role of exchange rate on private investment

Developing countries depend on capital product goods and imports to boost their economy and thus exchange rates are a crucial determinant in designing macroeconomic policies. Reducing expenditures and using domestic goods are part of adjustment programs that involve devaluing the currency to bring results for private investors. The effects of policies centered on exchange rates are difficult to determine because of the mechanisms that produce varied effects of private investment. These effects also change according to short and long run periods.

Currency devaluation affects investment in a summary of five channels defined by Chibber et al., 1992. The steps include; changing the supply price of capital goods, raising the price of imported goods, changing income distribution, changing actual income of consumers, and affecting the nominal and real interest rates. Changing income distribution involves increasing the product wages. Consumer's income affects demand for goods produced domestically. Nominal and interest rates also affect the capital supply price.

Devaluation affects the economy in a complex manner because the effects through various channels are in opposite directions. Devaluation has profound effect on aggregate demand, which greatly influences private investment. When devaluation through increased exportation, and economic growth, motivate final demand, the long run effect is likely to be positive. This also implies that the same effect is negative in the short run. Change in exchange rates affects the volume of exports and level of competition because it influences investment through the sectors that produce goods…

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