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Chapter 7
The Role of Government in an Economy
Part 1
Government Objectives & Policies
Government Objectives
Most national governments have four main economic objectives for their national economies. These are: • To achieve a low and stable rate of inflation in the general level of prices • To achieve a high and stable level of employment, and therefore a low level of unemployment • To encourage economic growth in the national output and income • To encourage trade and secure a favorable balance of international transactions.
A government may also have additional objectives which aim to improve the economic welfare of people in the economy, including: • To reduce poverty and reduce inequalities in income and wealth • To reduce pollution and waste, and therefore encourage more sustainable economic growth. If government can achieve these aims it will creates a favorable economic climate for business and improve people's living standards. For example, when prices are rising rapidly, consumers may not be able to keep up and may have to cut their demand for goods and services. As a result firms may cut back production and their demand for labour. Unemployment and the loss of wage income may cause hardship for many families. In addition, exports from the economy will become less competitive because of high prices and the balance of trade may become unfavorable and cause the exchange rate to fall. What is the Macroeconomy?
Macroeconomics is the study of how a national economy works with a view to understanding the interaction between growth in national income, employment and price inflation. In contrast, macroeconomics examines the economic behavior of individual consumers, household and businesses and how individual markets work.
Total demand and supply in a simple macroeconomy
. The total output of goods and services is paid for by the total expenditure of consumers, firms and government. Workers and owners of land and capital supply their resources to private firms and public sector organizations to produce those goods and services. In return they are paid income; their total income is therefore the national income.
Total expenditure or aggregate demand in a macroeconomy is therefore the sum of: • Consumers' expenditure on goods and services
• Investment expenditure by firms on new plant and machinery • Government expenditure on goods and services
• Spending from overseas on exports of goods and services from the economy
Total expenditure in an economy is therefore spent on the total or aggregate supply of all goods and services in the economy. This is the sum of all goods and services provided by private firms and public sector organizations in the economy. You will note that in a macroeconomy, government is both a produce, organizing land, labour and capital to provide goods and services such as healthcare, defence, roads and street lighting, and also a consumer of goods and services produced by private firms, including computers, paper and furniture for government offices.
Policy Instruments:
Governments can use different policy instrument, including taxes and regulations, to help achieve their objectives through their impact on the actions of producers and consumers. 1. Fiscal Policy:-
Fiscal Policy Involves varying total public sector expenditure and/or the overall level of taxation to influence the level of demand in an economy.
Expansionary Fiscal Policy:-
Expansionary fiscal policy may be used during an economic recession to boost demand for goods and services through tax cuts or increased public sector spending. Firms may respond by hiring more labour and increasing output. However, increasing demand can force up market prices and involve spending more on imported goods and services from overseas. Increasing imports will have a negative impact on the balance of payments. Increasing government spending and/or cutting taxes to boost aggregate demand, output and employment in an economy is known as expansionary fiscal policy. An expansionary fiscal policy usually means running or increasing a budget deficit. The budget refers to the amount a government has spend each year relative to the amount of revenue it raises from taxation. If government spending exceeds tax revenues in any year the budget will be in deficit. An expansionary fiscal policy that increases public expenditure and/or lowers taxes will therefore increase the budget deficit. To pay for the deficit a government will have to borrow money. Fiscal policy may also be used to redistribute incomes between rich and poor people in an economy. For example, taxes may be raised on people with high incomes and the money used to fund benefits and public services for people on low incomes, or those unable to work because they are old, sick or unemployed. Contractionary Fiscal Policy:
Contractionary fiscal policy may be used to reduce prices inflation. It involves reducing demand in an economy through tax increases or cuts in public sector spending. However, firms may respond to falling demand by cutting their output and reducing employment. Increased taxes may also reduce work incentives and therefore productivity.
Fiscal Policy instruments:-
|Fiscal policy instruments |Impacts on consumers |Impact on producers | |Increase income taxes |Disposable income is reduces and |Market prices and profits fall as consumer | | |consumer spending falls |demand falls, firms cut output and employment | |Reduce income taxes |Disposable incomes and consumer |Market prices and profits to rise so firms | | |spending rise |expend output and employ more labour | |Increase taxes on profits |Consumers are not directly affected but|After-tax profit fall. Firms may increase their | | |may pay higher prices if firms cut |prices and/or cut output in response | | |output | | |Cut taxes on profits |Consumers may benefit from reduced |After-tax profits rise. firms may expand their | | |prices as output rises |output and employment | |Increase indirect taxes on goods and |Consumers on low incomes may be hit |Consumer demand may contract and profits fall. | |services |hardest by price rises because they |Firms may cut output and reduce their demand for| | |spend all or most of their incomes |labour | |Cut indirect taxes on goods and |Consumers may expand their demand for |Expanding demand will boost profits which are an| |services |goods and services as after-tax prices |incentive to firms to raise their output and | | |fall |demand more labour | |Raise public expenditure |Public sector workers could be paid |Firms supplying goods and services to government| | |more. Low income families may receive |will enjoy increased revenues and profits, and | | |more benefits. More public services |may expand their output and employment | | |could be provided for free | | |Cut public expenditure |Public sector workers could suffer pay |A cut in public spending on capital projects, | | |cuts or be made unemployed. Welfare |such as road and school building, will cause | | |benefits may be reduced |cutbacks in the construction industry. Subsidies| | | |paid to other firms may be cut |
Problems with Fiscal Policy:
1. Fiscal policy is cumbersome to use
It is difficult for a government to know precisely when and by how much to expand public spending or cut taxes in a recession, or cut spending and raise taxes during a boom. Boosting aggregate demand by increasing public spending and/or cutting taxes may cause an economy to 'overheat'. That is demand may rise too much and too quickly. if the supply of goods and services to buy does not rise as quickly as demand there will be demand-pull inflation. On the other hand, a government may cut spending and raise taxes by too much following a period of high inflation and cause unemployment to rise.
2. Public spending crowds out private spending
To finance an increase in public spending and/or cut in taxation a government may borrow the money from the private sector. The more money the private sector lends to a government the less it has available to spend itself. This is called crowding out. To encourage people, firms and the banking system to lend money to the government it may raise interest rates. However, higher interest rates may discourage other people and firms from borrowing money to spend on consumption and investment. Reducing investment in modern and more productive equipment can reduce economic growth.
3. Raising taxes on incomes and profits reduce work incentives, employment and economic growth If taxes are too high, people and firms may not work as hard. This reduces productivity, output and profits. As productivity falls firms' costs increase and they are less able to compete on product price and quality against more efficient firms overseas. As a result demand for their goods and services may fall and unemployment may rise.
4. Expansionary fiscal policy i...