Fiscal policy, public debt, and economic growth DiPietro William R. Professor, Economics, Daemen College Online published on 29 June, 2013. Abstract This paper employs the variability of real government expenditure as a measure of fiscal policy and uses cross country regression analysis, first, to see whether fiscal policy is favorable for economic growth, and, second, to test the hypothesis that greater public debt tends to dampen the effectiveness of fiscal policy on economic growth. The results lend support to both contentions. Public debt is becoming a real worldwide concern. Debt is no longer just a problem of poor developing countries, but is now becoming a major issue for rich, highly developed countries as well. Europe is experiencing debt crisis in a number of its countries and even the U.S. is having difficulties raising debt ceilings in U.S. Congress. One of the potential consequences of high levels of public debt is that it may hamstring a government's ability to conduct fiscal policy. In order to sustain economic growth, a government needs to maintain adequate demand in the economy. Although private investment is critical for invention, innovation, capital accumulation, and economic progress, private investment is very fragile and erratic because it depends on the maintenance of demand in the economy. Investment depends on profits, and profits depend on sales, but sales ultimately depend on demand. To achieve economic growth, the government needs to create an environment conducive to investment. So that there will be high levels of investment and economic growth, it must assure sufficient demand. The main purpose of the paper is to investigate whether increases in the public debt dampen the clout of fiscal policy with regard to economic growth. As this presupposes that fiscal policy matters for economic growth, the study also needs to consider this question. A unique feature of the paper is that it employs, contrary to the typical measures of fiscal policy generally employed such as government spending, taxation, and budget deficits, an index of variation in government spending over time as a rough measure of overall fiscal policy use by government. The simple rationale for using a variation variable as a fiscal policy measure is that, on the spending side, over time, fiscal policy consists of the changes in government spending in response to changes in the state of the economy The paper is divided into five sections. The first section reviews some of the literature with regard to fiscal policy and its effect on the economy. The second section presents a simple two equation model explaining, first, the proposed relationship between economic growth and the employment of fiscal policy, and, second, the effect of debt on this relationship. The third section explains the variables that are used in the empirical section to estimate the model and provides the details on their sources. The fourth section presents the empirical results for cross country growth regressions, and the fifth section wraps the paper up with a short conclusion. Top |