The Role of Government

The public sector in every economy plays a major role, as a producer and employer.
Governments work locally, nationally and internationally. Here are the roles they
play in the economy:

As a producer, it provides, at all levels of government:

 Merit goods (educational institutions, health services etc.)

 Public goods (streetlights, parks etc.)
 Welfare services (unemployment benefits, pensions, child benefits etc.)
 Public services (police stations, fire stations, waste management etc.)
 Infrastructure (roads, telecommunications, electricity etc.).

As an employer, it provides at all levels of government:

 Employment to a large population, who work to provide the above mentioned goods
and services. It also creates employment by contracting projects, such as building
roads, to private firms.
 Support agriculture and other prime industries that need public support.
 Help vulnerable groups of people in society through redistributing income and
welfare schemes.
 Manage the macro economy in terms of prices, employment, growth, income
redistribution etc.
 Governments also manage its trade in goods and services with other countries by
negotiating international trade deals.
 Government Macroeconomic Aims
The government’s major macroeconomic objectives are:

 Economic Growth: economic growth refers to an increase in the gross domestic

product (GDP), the amount of goods and services produced in the economy, over a
period of time. More output means economic growth. But if output falls over time
(economic recession), it can cause:
1. fall in employment, incomes and living standards of the people
2. fall in the tax revenue the govt. collects from goods and services and
incomes, which will, in turn, lead to a cut in govt. spending
3. fall in the revenues and profits of firms
4. Low investments, that is, people won’t invest in production as economic
conditions are poor and they will yield low profits.

 Price Stability: inflation is the continuous rise in the average price levels in an
economy during a time period. Governments usually target an inflation rate it
should maintain in a year, say 3%. If prices rise too quickly it can negatively affect
the economy because it:
1. reduces people’s purchasing powers as people will be able to buy less with
the money they have now than before
2. causes hardship for the poor
3. increases business costs especially as workers will demand higher wages to
support their livelihood
4. makes products more expensive than products of other countries with low
inflation. This will make exports less competitive in the international
market.

 Full Employment: if there is a high level of unemployment in a country, the

following may happen:
1. the total national output (goods produced) will fall
2. government will have to give out welfare payments (unemployment
benefits) to the unemployed, increasing public expenditure while income
taxes fall – causing a budget deficit
3. Large unemployment causes public unrest and anger towards the
government.

 Income Redistribution: to reduce the inequality of income among its citizens, the
government will redistribute incomes from the rich to the poor by imposing taxes on
the rich and using it to finance welfare schemes for the poor. All governments
struggle with income inequality and try to solve it because:
1. widening inequality means higher levels of poverty
2. Poverty and hardship restricts the economy from reaching its maximum
productive capacity.
 Government spending
Governments spend on all kinds of public goods and services, not just out of
political and social responsibility, but also out of economic responsibility.
Government spending is a part of the aggregate demand in the economy and
influences its well-being. The main areas of government spending includes defense
and arms, road and transport, electricity, water, education, health, food stocks,
government salaries, pensions, subsidies, grants etc.

Reasons governments spend:

 To supply goods and services that the private sector would fail to do, such as public
goods, including defense, roads and streetlights; merit goods, such as hospitals and
schools; and welfare payments and benefits, including unemployment and child
benefits.
 To achieve supply-side improvements in the economy, such as spending on
education and training to improve labor productivity.
 To spend on policies to reduce negative externalities, such as pollution controls.
 To subsidise industries which may need financial support, and which is not available
from the private sector, usually agriculture and related industries.
 To help redistribute income and improve income inequality.
 To inject spending into the economy to aid economic growth.

Effects of government spending

 Increased government spending will lead to higher demand in the economy and
thus aid economic growth, but it can also lead to inflation if the increasing demand
causes prices to rise faster than output.
 Increased government spending on public goods and merit goods, especially in
infrastructure, can lead to increased productivity and growth in the long run.
 Increased government spending on welfare schemes and benefits will increase
living standards, and help reduce inequality.
 However too much government spending can also cause ‘crowding out’ of private
sector investments – private investments will reduce if the increase in government
spending is financed by increased taxes and borrowing (large government
borrowing will drive up interest rates and discourage private investment).
 Tax
Governments earn revenue through interests on government bonds and loans,
incomes from fines, penalties, escheats, grants in aid, income from public property,
dividends and profits on government establishments, printing of currency etc; but
its major source of revenue comes from taxation. Taxes are a compulsory payment
made to the government by all people in an economy. There are many reasons for
levying taxes from the economy:

 It is a source of government revenue: if the government has to spend on public

goods and services it needs money that is funded from the economy itself. People
pay taxes knowing that it is required to fund their collective welfare.
 To redistribute income: governments levy taxes from those who earn higher
incomes and have a lot of wealth. This is then used to fund welfare schemes for the
poor.
 To reduce consumption and production of demerit goods: a much higher tax is
levied on demerit goods like alcohol and tobacco than other goods to drive up its
prices and costs in order to discourage its consumption and production. Such a tax
on a specific good is called excise duty.
 To protect home industries: taxes are also levied on foreign goods entering the
domestic market. This makes foreign goods relatively more expensive in the
domestic market, enabling domestic products to compete with them. Such a tax on
foreign goods and services is called customs duty.
 To manage the economy: as we will discuss shortly, taxation is also a tool for
demand and supply side management. Lowering taxes increase aggregate demand
and supply in the economy, thereby facilitating growth. Similarly, during high
inflation, the government will increase taxes to reduce demand and thus bring down
prices. More on this below.

Qualities of a good tax system (the canons of taxation):

 Equity: the tax rate should be justifiable rate based on the ability of the taxpayer.
 Certainty: information about the amount of tax to be paid, when to pay it, and how
to pay it should all be informed to the taxpayer.
 Economy: the cost of collecting taxes must be kept to a minimum and shouldn’t
exceed the tax revenue itself.
 Convenience: the tax must be levied at a convenient time, for example, after a
person receives his salary.
 Elasticity: the tax imposition and collection system must be flexible so that tax rates
can be easily changed as the person’s income changes.
 Simplicity: the tax system must be simple so that both the collectors and payers
understand it well.
FISICAL POLICY
Fiscal policy is a government policy which adjusts government spending and
taxation to influence the economy. It is the budgetary policy, because it manages
the government expenditure and revenue. Government aims for a balance budget
and tries to achieve it using fiscal policy.

A budget is in surplus, when government revenue exceed government spending.

While this is good it also means that the economy hasn’t reached its full potential.
The government is keeping more than it is spending, and if this surplus is very
large, it can trigger a slowdown of the economy.

When there is a budget surplus, the government employs an expansionary fiscal

policy where govt. spending is increased and tax rates are cut.
A budget is in deficit, when government expenditure exceeds government revenue.
This is undesirable because if there is not enough revenue to finance the
expenditure, the government will have to borrow and then be in debt.

When there is a budget deficit, the government employs contractionary fiscal

policy, where govt. spending is cut and tax rates are increased.
Fiscal policy helps the government achieve its aim of economic growth, by being
able to influence the demand and spending in the economy. It also indirectly helps
maintain price stability, via the effects of tax and spending.

Expansionary fiscal policy will stimulate growth, employment and help increase
prices. Contractionary fiscal policy will help control inflation resulting from too much
growth. But as we will see later on, controlling inflation by reducing growth can lead
to increased unemployment as output and production falls.
MONETARY POLICY
The money supply is the total value of money available in an economy at a point of
time. The government can control money supply through a variety of tools
including open market operations (buying and selling of government bonds) and
changing reserve requirements of banks. (The syllabus doesn’t require you to study
these in depth)
The interest rate is the cost of borrowing money. When a person borrows money
from a bank, he/she has to pay an interest (monthly or annually) calculated on the
amount he/she borrowed. Interest is also be earned on the money deposited by
individuals in a bank.
(The interest on borrowing is higher than the interest on deposits, helping the banks
make a profit).
Higher interest rates will discourage borrowing and therefore, investments; it will
also encourage people to save rather than consume (fall in consumption also
discourage firms from investing and producing more).
Lower interest rates will encourage borrowing and investments, and encourage
people to consume rather than save (rise in consumption also encourage firms to
invest and produce more).

The monetary authority of the country cannot directly change the general interest
rate in the economy. Instead, it changes the interest rates of borrowing between
the central bank and commercial banks, as well as the interest on its bonds and
securities. These will then influence the interest rate provided by commercial banks
on loans and deposits to individuals and businesses.

Monetary policy is a government policy controls money supply (availability and cost
of money) in an economy in order to attain growth and stability. It is usually
conducted by the country’s central bank and usually used to maintain price
stability, low unemployment and economic growth.

Expansionary monetary policy is where the government increases money supply by

cutting interest rates. Low interest rates will mean more people will resort to
spending rather than saving, and businesses will invest more as they will have to
pay lower interest on their borrowings. Thus, the higher money supply will mean
more money being circulated among the government, producers and consumers,
increasing economic activity. Economic growth and an improvement in the
balance of payments will be experienced and employment will rise.
Contractionary monetary policy is where the government decreases money supply
by increasing interest rates. Higher interest rates will mean more people will resort
to saving rather than spending, and businesses will be reluctant to invest as they
will have to pay high interest on their borrowings. Thus, the lower money supply will
mean less money being circulated among the government, producers and
consumers, reducing economic activity. This helps slow down economic growth
and reduce inflation, but at the cost of possible unemployment resulting from the
fall in output.