COVER PAGE – TO BE COMPLETED BY THE STUDENT

Department of Economics

Coursework Submission Form

Candidate Number: 16631

Unit: ES10010

Unit Convenor:
DR Matteo De Tina
Student’s Department:
Accounting and Finance
Word Count: 1587

Title / Question: “Analyse the relationship between government

spending and investment spending for the US
economy in the past 20 years. Discuss whether
there is a correlation and/or causation.”

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The US economy is built up of different components which all add up to calculate the total
output of the country, its GDP. It can be argued that two components which play a pivotal
role in a country’s economy are its governments expenditure and the level of private
domestic investment. These components alongside consumption account for a large
percentage of the US GDP. Therefore, the evaluation of the role of these components and
their relationships is vital to measure the efficiency of the economy and where it may be
improved. Throughout the history of the US changes in levels of government spending has
caused crowding-out and crowding-in effects with regards to private investment. The
crowding-out effect is thought to occur when private investments and public spending are
competing with each other through the channel of the interest rates. (Kim and Lee, 2014)
This is amplified through times of recessions and booms where it is essential for
government to use fiscal and monetary policies to stabilise the economy. Using the graphs
and data below we can analyse and evaluate the relationship between government and
investment spending in the US economy and whether a correlation and or causation effect
is in place between the two variables.

Comparison of GDP contributors in the US economy

20000.00
18000.00
16000.00
Value in US $ Billions

14000.00
12000.00
10000.00
8000.00
6000.00
4000.00
2000.00
0.00
1999-01-01
1999-10-01
2000-07-01
2001-04-01
2002-01-01
2002-10-01
2003-07-01
2004-04-01
2005-01-01
2005-10-01
2006-07-01
2007-04-01
2008-01-01
2008-10-01
2009-07-01
2010-04-01
2011-01-01
2011-10-01
2012-07-01
2013-04-01
2014-01-01
2014-10-01
2015-07-01
2016-04-01
2017-01-01
2017-10-01
2018-07-01

Quaterly, Seasonally adjusted

Real GDP Government total expenditure Gross private domestic investment

Figure 1, FRED (2019)

In the graph above we can see the value in billions of US$ that each component contributes
towards the GDP of the US economy over a 20-year time frame. By analysing the data set
we can sum that on average government spending accounts for 33% of the US GDP whilst
private investment accounts for 16%, proving the vital role that both components play in
the US economy. However, in the graph it is clear that these percentages change overtime,
and as highlighted by the 2008 financial market crash, we can see that in times of recession
government spending increases whilst private investment falls, a negative correlation
between the 2 variables. Following the 2008 financial crisis the US government had to use
bail out funds to stabilise the troubled financial market. (Kim and Lee, 2014) This sheer scale
of increased government spending amplified the governments level of borrowing, which
was used to avoid the collapse of the financial markets, resulting in the temporary increase
in the base interest rates. Consequently, borrowing for private investment increased in price
leading to the steep dip in the value of private investment in the US economy which may be
noted in the 2nd quarter of 2009, as the investment in capital goods had become too costly
for businesses. At this point it is calculated that 37% of the US GDP resulted from
government spending whilst private investment dropped to accounting for only 12%. This
gives us the primary evidence of the crowding out effect in place as the rise in government
spending resulted in the decreased level of private investment in capital goods. The
relationship between the two variables during the number of years around the 2008 US
financial market crash shows a negative correlation and begins to provoke ideas of
causation between the variables.

This crowding-in relationship is also highlighted in the dot com crash of the early 2000’s. By
analysing the percentage change in value of government expenditure and private
investment we can again identify a crowding-out trend between the two variables.

Percentage change during and after the dot com bubble

8.0

6.0

4.0
Percentage change

2.0

0.0
1999-01-01
1999-03-01
1999-05-01
1999-07-01
1999-09-01
1999-11-01
2000-01-01
2000-03-01
2000-05-01
2000-07-01
2000-09-01
2000-11-01
2001-01-01
2001-03-01
2001-05-01
2001-07-01
2001-09-01
2001-11-01
2002-01-01
2002-03-01
2002-05-01
2002-07-01

-2.0 2002-09-01

-4.0

-6.0
Date observed

Private investment Government expenditure Real GDP

Figure 2, FRED (2019)

In the graph above it is evident that government spending and private investment follow a
similar pattern in percentage change. However, we can also see that at times of lows in
government spending private investment shoots up. A case of this can be seen in the 1st
quarter of 2000, both government spending and private investment had experienced a
percentage change of about -0.4, but right after for the following 2 quarters private
investment shoots up. This is a delayed reaction from businesses and corporations to the
declining government spending seen in the back end of 1999. It can be assumed that the
cause of this is the lengthy decision-making process that businesses go through before
deciding to take on some private investment and purchase capital goods. By analysing the
correlation coefficient for the two variables between this period we can see that they have a
correlation of 0.11, therefore no significant evident correlation. Due to this low correlation
coefficient the probability of a causation effect becomes more likely. A low correlation
implies that the two variables do not move together. Therefore, we can begin to investigate
whether one causes the movement of the other. Since private investment its typically a
debt funded activity it can be assumed that the impact that government spending has on
the base interest rates will play a pivotal role in the level of private investment. Therefore,
using the graph above it, can be assumed that increased government spending raises base
interest rates which in turn declines the level of private investment evident in the US
economy during the dot com bubble and crash. This is also true for its inverse, decreased
government spending encourages private investment. Both show support for the crowding-
out and crowding-in effects.

Effective Federal Funds Rate, Percent

7

5
Base interest rate

0
1999-01-01
1999-09-01
2000-05-01
2001-01-01
2001-09-01
2002-05-01
2003-01-01
2003-09-01
2004-05-01
2005-01-01
2005-09-01
2006-05-01
2007-01-01
2007-09-01
2008-05-01
2009-01-01
2009-09-01
2010-05-01
2011-01-01
2011-09-01
2012-05-01
2013-01-01
2013-09-01
2014-05-01
2015-01-01
2015-09-01
2016-05-01
2017-01-01
2017-09-01
2018-05-01

Date observed

Figure 3, FRED (2019)

It is evident that on the 2000-05-01 the interest rates peaked and consequently the private
investment rate seen in Figure 2 dropped steeply in the response of the increased cost of
borrowing.
Moreover, the studied data set also provides key evidence to support the theory of
crowding-in, ‘when the government shrinks, the private economy has more money and
room to expand’ (Wall Street Journal,2014). In figure 4 we can see that in the build up to
and during the 2008 financial market crisis the rates of change between base interest rates
and private investment again show a delayed negative correlation between the two.
However, after the US government noticed the steep decrease in the level of private
investment during the crash they knew they needed to act upon and change their fiscal
policy in order to try and increase the level of private investment. These actions would in
turn increase the purchase of capital goods, reduce unemployment and ultimately pull the
US economy out of the recession period. In order to do so they began to decrease the base
interest rates (refer to Figure 3) in the last quarter of 2007. This can be seen to have an
instant effect on the level of private investment as its percentage change grew from -12.7%
in the 3rd quarter of 2009 to 8.5% in the 3rd quarter of 2010. This provides prime evidence of
the decreased level of government spending and involvement in the US economy during the
back end of the financial crisis led to private investment increasing effectively “crowding-in”
the investors. In Figure 4 it can also be noted that the base interest rate has maintained a
close to zero level this is in an attempt to help recover the US economy post crash by
keeping the cost of borrowing low. ‘The interest rate is controlled at a very low level by the
Federal Reserve and will remain very low until some obvious signs of recovery from the job
markets according to Janet Yellen, the current chair’. (Kim and Lee, 2014)

Effective Federal Funds Rate against percentage change of

private investment
10.0
Percentage Change; Interest rate

5.0

0.0
1999-01-01
1999-10-01
2000-07-01
2001-04-01
2002-01-01
2002-10-01
2003-07-01
2004-04-01
2005-01-01
2005-10-01
2006-07-01
2007-04-01
2008-01-01
2008-10-01
2009-07-01
2010-04-01
2011-01-01
2011-10-01
2012-07-01
2013-04-01
2014-01-01
2014-10-01
2015-07-01
2016-04-01
2017-01-01
2017-10-01
2018-07-01
-5.0

-10.0

-15.0
Date observed

Private investment FEDFUNDS

Figure 4, FRED (2019)

Conversely, although the above data suggests a strong relationship between government
spending and private investment, the role of an external, third factor which may lead to this
correlation must be considered. As seen above the data analytics were conducted around
two of the US major recessions in the past 20 years. This period of recession could play a
role in creating a relationship between government spending.
 Changing rates of Private Investment, Government
Expenditure and Federal Funds Rate
10.0

8.0
Percentage change; interest rate

6.0

4.0

2.0

0.0
2009-07-01
2009-11-01
2010-03-01
2010-07-01
2010-11-01
2011-03-01
2011-07-01
2011-11-01
2012-03-01
2012-07-01
2012-11-01
2013-03-01
2013-07-01
2013-11-01
2014-03-01
2014-07-01
2014-11-01
2015-03-01
2015-07-01
2015-11-01
2016-03-01
2016-07-01
2016-11-01
2017-03-01
2017-07-01
2017-11-01
2018-03-01
2018-07-01
-2.0

-4.0
Date observed

Private investment Government expenditure FEDFUNDS

Figure 5, FRED (2019)

For example, post 2008 financial crash, base interest rates and government spending
became more settled and the scale of fluctuations had stopped. However, private
investment did not mirror this behaviour and maintained its volatility throughout the years
following the financial market crash. By calculating the variance of the data set we can see
that government spending has an average variance of 1.71, whilst private investment has an
average variance of 10.1. However, post-crash these figures change to 0.82 for government
spending and 5.26 for private investment. This shows that although the volatility of
government spending has decreased, the volatility of private investment, although
dampened, still remains very high. This could suggest that the recessions periods in the US
economy play a vital role in establishing the correlation between these two variables which
during periods outside of recession do not have such a prominent relationship.

In conclusion I believe that there is undoubtable a relationship between private investment

and government spending in the US economy over the past 20 years. As is shown in the
above analysis there seems to be a delayed negative correlation between the two variables.
The above data also shows evidence leaning towards a causation effect where and increase
in government spending triggers a decrease in private investment overtime, causing the
crowding out effect. This is also true for the inverse. However, it can be argued that there is
an element of reverse causality as both variables trigger responses in each other’s actions
and the effect they have on the economy. Furthermore, it can be argued that the
relationship between government spending and private investment is influenced by the
external third factor which is the recession periods of the US economy. In summary I believe
that there is sufficient evidence to conclude that there is a relationship present between the
two variables, however further empirical testing should be conducted to evaluate the
correlation and causation effect between the government spending and private investment.
References

1. Kim, Yeon Joon. "Sluggish Recovery from the Financial Crisis: Crowding-out Effect
and Contagion." Global Economic Review 43.4 (2014): 408-29. Web.
2. Anonymous. "Less Government, Faster Growth; Private Spending and Investment Lift
the Economy in the Fourth Quarter." Wall Street Journal (Online) [New York, N.Y.]
2014: N/a. Web.
3. U.S. Bureau of Economic Analysis, Real Gross Domestic Product [GDPC1], retrieved
from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/GDPC1, April 14, 2019.
4. U.S. Bureau of Economic Analysis, Gross Private Domestic Investment [GPDI],
retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/GPDI, April 14, 2019.
5. U.S. Bureau of Economic Analysis, Government total expenditures
[W068RCQ027SBEA], retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/W068RCQ027SBEA, April 14, 2019.
6. Board of Governors of the Federal Reserve System (US), Effective Federal Funds Rate
[FEDFUNDS], retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/FEDFUNDS, April 15, 2019.