MONETARY POLICY REPORT | SPRING 2024 (box 1)
(authors: Jan Brůha, Karel Musil, Zdeněk Pikhart)
Investment activity in the Czech economy is gradually picking up following a sharp decline in 2020 caused by Covid. In real terms, however, it was still almost 3% below the end-2019 level (and, in the case of private investment, even 5.5% below that level) in 2023 Q4. Moreover, growth in private investment slowed last year due to tight domestic and foreign monetary conditions and problems in the German economy, the Czech Republic’s largest trading partner. As a result, the year-on-year increase in total gross fixed capital formation growth was driven by the investment efforts of general government. Although this sector’s share of total gross fixed investment has long been below 20% (18.9% in 2023), its contributions to growth in overall investment activity have been relatively significant in individual years (see Chart 1). The increased volatility of government investment in the past was due in part to the financing of projects from EU funds. Owing to the official end of the 2007–2013 programme period (and the n+2/3 rule with a slight time lag), domestic entities made great efforts to draw down as much as possible of the allocation (i.e. the funds earmarked for public and private investment projects in the Czech Republic in the said period). This led to a surge in government (and private) fixed investment growth in 2014 and especially 2015 and related sizeable drawdown of capital subsidies and subsequent receipt of cross-border payments from the European Commission. Due to better project administration, there was no similar peak in the drawdown of EU funds around the end of the 2014–2020 programme period. EU funds were thus drawn down more evenly in this period.
Chart 1 – The contributions of general government to growth in real fixed investment are significant
y-o-y growth in %; contributions in pp; source: CZSO
The impact of general government investment on inflation is not one-sided and direct, as it depends on a range of factors: the time horizon, the position of the economy in the cycle, the manner of financing, the type and duration of the investment and potentially other effects. For illustration, the main effects of investment are described in the text as ceteris paribus, that is, in isolation, with all other things being equal. In the real world, however, the factors often interact.
As regards the time horizon, the effects of general government investment can be divided into short- and long-term ones. In the short term, the income effect of investment activity dominates, as additional government investment expenditure increases aggregate demand and income, which can then be spent. The lower the marginal propensity to save, tax and import in the related revenue and expenditure stream of a domestic small open economy, the higher the overall stimulating effect. Growth in domestic demand, ceteris paribus, pushes the economy towards greater capacity utilisation and higher profit margins. Government investment thus has an upward effect on inflation in the short run. Unlike current (consumption) expenditure, however, government investment also usually has a capacity-building effect, stimulating growth in potential output. It thus expands the economy’s production capacity, allowing it to produce more goods and services. By contrast, an increase in the production capacity of the supply side of the economy at a given level of aggregate demand, ceteris paribus, reduces the price level. Chart 2 shows that capital stock formation by general government was almost negligible in the Czech Republic from the mid-1990s until 2022 relative to the private sector. This was due in roughly equal measure to wear and tear of existing capital and to new fixed investment formation. The share of general government in the fixed capital stock thus fell steadily in this period from an initial 39% to 26% in 2022. But even this does not rule out government investment having a long-term capacity-building, productive and hence latent anti-inflationary effect. The replacement of old capital with more modern, more efficient capital usually fosters growth in factor productivity, whether through the general technical and technological level or through the creation of a higher-quality institutional framework for the development of the private economy. In both cases, this usually results in better services and public goods. Chart 3 shows the positive relationship between the government investment ratio and economic growth on a cross-sectional sample of European economies. However, the causality can run in both directions, as a higher government investment ratio can boost growth, and a faster-growing economy will in turn make it possible to finance a higher government investment ratio.
Chart 2 – General government has made a minimal contribution to cumulative growth in the capital stock in the Czech Republic
constant 2015 prices; in CZK billions; right-hand scale in %; source: CZSO
Chart 3 – A higher government investment ratio is associated with high GDP growth
x-axis: government investment-to-GDP ratio in %; y-axis: real GDP growth in %; averages for 2011–2022; source: Eurostat
The overall context – above all the cyclical position of the economy – also plays an important role in assessing the impacts of government investment. Its effect on inflation may theoretically be different if the economy is above its potential and different if it is below it. If an economy is below its potential, government investment can foster growth without increasing inflation significantly, as firms (capital goods producers and other firms along the chain) will not be forced to increase their prices and margins as long as they have spare production capacity, sufficient labour and half-empty order books. In an overheating economy, by contrast, additional general government investment demand will make the labour market tighter and put upward pressure on wages; it may also increase the profit margins of producers of capital (and other) goods. The central bank will thus be forced to respond to the rising inflation pressure by tightening monetary conditions, which usually crowds out private spending to some extent. That fiscal policy is more effective in economic downturns is an empirical finding; government investment is no exception in this respect.[1] The same applies at the zero lower bound on interest rates.[2] The multiplier effect of government investment is estimated at close to 0.7 for the Czech Republic.[3]
Overall capitalisation is also important. In highly under-invested countries and regions, every additional government investment has greater long-term supply effects than when investment needs are saturated and the capital stock is sufficient. To assess the benefits of government investment, the decreasing marginal productivity of capital can be proxied by the traditional concept of the incremental capital output ratio (ICOR). The ICOR characterises the amount of investment needed to produce an additional unit of output. Lower ICORs imply a higher marginal return on investment and hence an ability to produce a unit increment of output at less cost. ICORs were often used in the past to make international comparisons,[4] whereas now their use is limited mostly to assessing investment plans at the micro level. One reason for this is that the ICOR favours developing countries, which can increase their infrastructure capacity to a greater extent than developed countries, which tend to have established infrastructure. However, the logic of the ICOR is still relevant – given the limited resources of governments and the costs associated with financing, it is appropriate to select investment projects that are more effective.
In Europe, the manner of investment financing also needs to be taken into account. Using data for the Czech Republic, Pikhart (2019, see footnote 3) analysed the different impacts of European funds on private and government investment. Private investment activity tends to be driven by economic fundamentals (profitability, capacity utilisation, developments abroad and monetary conditions), while the availability of EU funding itself changes the structure of funding rather than increasing total investment. By contrast, capital sources from EU funds used in the general government sector are almost fully reflected in an increase in total domestic investment (see also the additionality principle[5]). However, growth in government investment financed from domestic sources can crowd out other private investment expenditure, again depending on the position of the economy in the cycle. According to the above study, the average crowding out effect of domestic government investment in the Czech Republic ranges between 20% and 30% of the initial amount invested. This weakens both the inflationary effect on the demand side and the long-term latent disinflationary effect on the supply side, because part of the private investment (and the related growth in the capital stock) will be missing as a result of crowding out.
The type of government investment can also be an important factor. Investment focused on promoting growth of the supply side of the economy has the greatest inflationary potential. However, this depends on the type of investment that would serve this purpose most effectively in the country concerned. There is no universal answer. A country with desperately under-invested transport infrastructure, for example, may benefit the most from investing in a motorway network connecting large cities and accelerating their development. Likewise, investment in weapon systems may yield by far the highest rate of return and be the most useful for a country facing a substantial security threat. By contrast, an advanced economy in which those areas are sufficiently developed may benefit from investing in knowledge and R&D. Chart 4 illustrates the material structure of general government investment in the Czech Republic, the largest component of which is infrastructure construction. There are many other aspects which play a role in assessing the effectiveness and impact of government investment activity in practice. These include the level of corruption, regulation, the length and red tape of authorisation procedures, social and environmental aspects and the temporary nature of measures.
Chart 4 – Economic affairs, especially transport infrastructure, dominate the material structure of general government investment in the Czech Republic
shares in 2022; source: CZSO
For the purposes of this box, a temporary increase in general government investment spending of 1% of GDP spread over one year was simulated using the g3+ core prediction model. This increase affects the real economy and inflation through two channels. The first, immediate channel raises aggregate demand through the standard (new-)Keynesian income-expenditure mechanism, hence increasing economic growth and inflation pressures. The second channel fosters growth in the capital stock and represents a positive supply shock, increasing growth and having an anti-inflationary effect. This second channel operates with a lag and is modelled in the simulation using an increase in investment productivity. It was calibrated to correspond to an increase in the capital stock of 70% of the government investment impulse. This reflects the crowding out of private investment by government investment. We could consider a smaller level of crowding out, and hence a greater effect on capital productivity, if we conducted the simulation during a recession, when a significant part of production capacity is unused, or at the effective lower bound on interest rates.
The real economy is initially favourably affected by the demand effect, which is later bolstered by the supply effect (see Chart 5). The effects on inflation go in opposite directions: the investment impulse is initially inflationary at the two-year horizon, but an anti-inflationary supply effect then starts to prevail (see Chart 6). This profile is consistent with the findings of research conducted at other central banks. For example, de Jong et al. (2017)[6] conclude that an increase in general government investment has an inflationary effect in the short term. The exception is the situation where growth in government investment is financed by reducing government consumption. In such case, the short-term inflationary effect of increased aggregate demand would be suppressed and the overall effect of government investment growth would be anti-inflationary.
Chart 5 – General government investment initially has a demand effect on GDP growth, with a supply effect prevailing only later
x-axis: number of quarters; y-axis: impact of general government investment on GDP growth in pp; CNB calculations
Chart 6 – The demand effects of general government investment are inflationary, while the supply effects are anti-inflationary with a lag
x-axis: number of quarters; y-axis: impact of general government investment on inflation in pp; CNB calculations
To sum up, general government investment – especially investment focused on promoting economic growth – has the potential to strengthen the supply side of the economy and generate long-term macroeconomic benefits and growth in living standards (wealth). Effectively targeted investment affects not only demand, but also supply. It can thus have a favourable effect in the long term, as it supports growth by raising productivity and hence stimulates growth in aggregate demand, which will start to exert implicit (latent) downward pressure on inflation. Whether demand in the economy is managed in such a way as to make the above price (anti-inflationary) effect of government investment growth consistent with maintaining price stability will then depend on the central bank’s response and on other macroeconomic stabilisation policies.
[1] See Gechert, S., Rannenberg, A. (2018): Which fiscal multipliers are regime-dependent? A meta-regression analysis.
[2] As shown in Bouakez, H., Guillard, M., Roulleau-Pasdeloup, J. (2017): Public investment, time to build, and the zero lower bound.
[3] See, for example, OECD Economic Outlook, Interim Report March 2009: The effectiveness and scope of fiscal stimulus, Ambriško, R. (2017): Growth-friendly fiscal strategies for the Czech economy and Pikhart, Z. (2019): Metodika predikce tvorby hrubého fixního kapitálu v ČR.
[4] See, for example. Walter, A. A. (1966): Incremental capital-output ratios, Leibenstein, H. (1966): Incremental capital-output ratios and growth rates in the short run, Vanek, J., Studenmund, A. H. (1968): Towards a better understanding of the incremental capital-output ratio, Gianaris, N. V. (1970): International differences in capital-output ratios and Sato, K. (1971): International variations in the incremental capital-output ratio.
[5] The additionality principle states that EU structural and investment funds’ contributions must not replace public or equivalent structural expenditure by a Member State in the regions concerned.
[6] De Jong, J., Ferdinandusse, M., Funda, J., Vetlov, I. (2017): The effect of public investment in Europe: A model-based assessment.