Public economics: principles and applications

Public Economy

The percentage of government spending as a proportion of GDP is often used as a measure of the size of government is this measure typically correlated with the underlying influence of the government in the economy? Please explain. Then describe potential problems with this measure very clearly, illustrating the argument in your answer with relevant examples.

It might be tempting to make an easy correlation between a high level of government involvement in the economy and a high percentage of the GDP coming from government expenditures. However, although there is certainly a correlation between the size of a government and government spending as a proportion of GDP, it is not necessarily the case that the greater the government's expenses as proportion of GDP, the greater the size of the government and its influence in the economy. For example, during World War II and the arms build-up of the 1980s, the American government spent a great deal of money manufacturing armaments, and on contracting different industries to produce various kinds of military devices. However, the Regan administration of the 1980s actually emphasized deregulation of private industry, rather than regulation, and the increase of government involvement in the economy during the 1940s was not nearly as marked as it was during the New Deal ten years previously.

It is true that many European nations with substantial social welfare infrastructures have a high degree of influence upon their economies. However, of the developed countries, Korea spends by far the least as a proportion of GDP, around10% or 15% and it is not the 'least involved' nature in terms of its construction of a social welfare state ("U.S. Government Spending as a Percentage of GDP," Carried Away, 2003). The U.S. follows at 30% but Japan, which possesses a much more regulated society and offers more benefits to its citizens, is measured at 32%, and the U.K. At 38% ("U.S. Government Spending as a Percentage of GDP," Carried Away, 2003). The UK's percentage it lowest rate of any European Union country, but the government is still highly involved in the economy.

Furthermore, for every year of the current Bush's four years in office, federal spending as a percentage of GDP increased annually. But during every year of Clinton's term in office it decreased ("U.S. Government Spending as a Percentage of GDP," Carried Away, 2003). This is despite the fact that the Republican president said that he was committed to deregulation, dismantling the social welfare state, and to less involvement on the part of the government in the national economy. Thus, for the United States, involvement of the government in the economy is not correlated perfectly with the government's percentage of expenditures as measured in as a proportion of GDP. Rather the greater correlation may be the nation's expenditures upon defense. Recessions, and the need to spend more on unemployment benefits and to stimulate the economy through government spending may also result in an increase of government spending in relation to GDP, but only in the short-term, regardless of the administration's desire to regulate the economy.

The government of Canada has outstanding debt of approximately $550 billion. To service the debt, it issues bonds. The government has also announced previously that it is committed to fighting inflation. Please explain clearly how government debt management policy can lend credibility to the government's fight against inflation. In doing so, provide a clear explanation of the key differences between indexed and nominal debt.

When a government wishes to curb inflation, one of the most effective ways to use the monetary supply to do so is to sell securities, in short through the sale of government bonds. By selling government securities, the government takes money or liquid capital out of the economy, and makes it more attractive to save rather than to spend money. Also, selling government bonds can reduce government debt. Reducing government debt is an important goal for any administration because the higher the debt, the less that nation's currency is usually valued abroad. Ordinary citizens will have to pay more for imported goods, which makes the cost of living even higher. Inflation is dangerous for the pocketbooks of citizens because wages tend to go up at slower pace than prices.