Working Capital Finance and the Balanced Budget Multiplier

By Chang, Wen-ya; Lai, Ching-chong | American Economist, Fall 1992 | Go to article overview

Working Capital Finance and the Balanced Budget Multiplier


Chang, Wen-ya, Lai, Ching-chong, American Economist


I. Introduction

The macroeconomic literature has long agreed that the balanced budget multiplier is positive. More specifically, the standard belief |Wallich (1944), Haavelmo (1945), Dornbusch and Fischer (1990)~ indicates that an increase in government spendings, accompanied by an equal increase in taxes, will generate an expansion in the national income.(1) The purpose of this paper is to question this conventional wisdom by explicitly taking the status of working capital finance on the production process into consideration.

The role of working capital finance on economic activities has received increasing attention in the literature, particularly in the so-called structuralist macromodel. This strand of research emphasizes that in most developing countries the working-capital cost is an expense of doing business, since it should be paid in advance as the production process is initiated. In the context of working-capital finance consideration, Shaller (1983) and Mitchell (1984) reevaluate the performance of fiscal policy, and find that an expansion in government expenditure will actually depress the domestic output. Sauernheimer (1987) as well as Chang, Lai and Chu (1990) apply the role of working capital finance to the open economy, and find that the Shaller-Mitchell conclusion may not hold in the context of flexible exchange rates. On the other hand, Taylor (1983, ch. 5) and van Wijnbergen (1983) demonstrate that monetary contraction may lead to stagflation should the cost-push effect created by working capital be substantially dominant. In line with these studies, this paper turns its attention to explore the implication of working-capital cost on the balanced budget multiplier. It can be found that the balanced budget multiplier may be negative depending on the extent of working-capital cost.

The remainder of the paper is organized as follows. The theoretical framework characterized by the working-capital cost is presented in section II. Section III examines the balanced budget multiplier as well as derives a graphical illustration. Finally, the concluding remarks are given in section IV.

II. The Theoretical Framework

Except for the fact that the government will maintain a balanced budget via changes in the income tax rates and that the aggregate supply function embodies the feature of working capital finance, the analytical framework is basically that of the standard aggregate demand and aggregate supply (AD-AS) as model. The model consists of the following set of equations:

y = C(y - |Tau~y) + I(r) + G, (1)

M/p = L(r, y), (2)

y = S(p, r), (3)

G = |Tau~y; (4)

where y = national income, C = consumption expenditure, |Tau~ = a proportional income tax rate, I = investment expenditure, r = interest rate, G = government expenditure, M = nominal money supply, p = domestic price level, L = real money demand, S = aggregate supply function. As customary, we impose the following restrictions on the behavioral functions: 1 |is greater than~ c |equivalent to~ dC/d(y - |Tau~y) |is greater than~ 0, |I.sub.r~ equivalent to~ dI/dr |is greater than~ 0, |L.sub.r~ |equivalent to~ |Delta~L/|Delta~r |is less than~ 0, |L.sub.y~ |equivalent to~ |Delta~L/|Delta~y |is greater than~ 0.

Equations (1) and (2) are the equilibrium conditions for the commodity market and money market, respectively.(2) Equation (3) represents the economy's aggregate supply function. Since the aggregate supply function will play a significant role on evaluating the balanced budget multiplier, we now turn to derive this function in detail.

Define labor employed as N, the aggregate short-run production function can then be written as

y = y(N), (5)

where |y.sub.N~ |equivalent to~ dy/dN |is greater than~ 0 and |Y.sub.NN~ |equivalent to~ |d.sup.2~Y/d|N.sup.2~ |is less than~ 0.

Empirical studies, such as Morley (1971), suggest that in most developing countries, supplier of inputs are too financially constrained to allow their payments to wait. …

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