THE ROLE OF GOVERNMENT

The government can operate at 3 levels

(a). Local role

-The government collects taxes which it uses to fund local services such as,

(i) rubbish collection

(ii) street lighting

(iii) public parks

(iv) hospitals

(v) schools

(vi) libraries

-The government ensures that sufficient public and merit goods are provided.

(b) National role

-The central government makes decisions about how to achieve its macroeconomic aims

-Macroeconomics is the study of the whole economy

-The government aims to achieve the following aims; economic growth, stable price, low
unemployment, balance of payment equilibrium.

- The following policies may be used by the government;

(i) Fiscal policy

(ii) Monetary policy

(iii) supply side policies

(iv) policies to protect the environment

(c) International role

-This is when a country participates in trade with other countries

-An economy may join a trading bloc which promotes free movement of goods and services between
member countries.

-A country may also impose tariffs and quotas to reduce the amount of goods from other countries.
MACROECONOMIC AIMS OF THE GOVERNMENT

Macroeconomics is concerned with the whole economy

5 macroeconomic aims of the government

1.Full employment or low unemployment

-unemployment refers to the number of people who are willing and able to work but cannot find jobs.

-it is the role of the government to reduce the rate of unemployment in the economy.

-unemployment is not good because it causes the following problems;

(i) increased crime rate (ii) family disputes (iii) decay in unused skills (iv) increased poverty

(v) higher government spending on welfare services

-unemployment rate is calculated by the formula ---

-working population refers to all the employed, and all those seeking work. It is also known as the
economically active group

-e.g if 5m people are unemployed out of a labourforce of 40m, the unemployment rate is 12,5%

-Low unemployment is beneficial because;

(i) it promotes economic growth because more people are producing goods and services

(ii) increases the standards of living in a country

(iii) Represents greater efficiency in the use of a country’s resources

2. Price stability (control of inflation and deflation)

-Inflation is the persistent rise in the general level of prices in the economy.

-low and stable rates of inflation are vital to achieving economic stability and social wellbeing

-high rate of inflation causes the following problems

(i) makes planning difficult (ii) higher export prices which reduces their competitiveness (iii) reduced
savings (iv) workers will demand for higher wages (v) low living standards because goods are expensive.

However slight rise in prices is good because (i) it encourage producers to increase their output

(ii) it encourages investment

3.Economic growth

It is the increase in a country’s output over time or an increase in a country’s real gross domestic(GDP)
over time.

-economic growth is shown by an outward shift of the production possibility curve(PPC)

-economic growth brings greater prosperity to an economy and therefore tends to raise the standard of
living.

-economic growth is achieved through the following

(i) improvement in education (ii) technological development (iii) discovery of new natural resources

(iv) higher rate of saving

4. balance of payment stability

-balance of payment is a record of a country’s financial transactions with other countries

-exports represent an inflow of money into a country and imports represents an outward flow of money
from the economy.

-if imports are more than exports it means that the country is living beyond its means and it will be in
debt

-a bop deficit occurs when a country’s imports are more than its exports

-a bop surplus occurs when a country’s exports are more than its imports

-while a bop deficit drains money from the economy, the bop surplus may also be undesirable since it
may result in inflation in the long run.

5. Redistribution of income

-A government may seek to redistribute income from the rich to the poor.

-this is achieved through taxing the rich and increasing spending on welfare services

-by using the progressive tax system, the government can raise money to assist the poor
-the money will be spend on unemployment benefits, housing benefits, education and health facilities,
subsidies

The world’s richest billionaires, March 2016

Ranking Billionaire Wealth (US$)

1 Bill Gates 75
2 Amancio Ortega 67
3 Warren Buffett 61
4 Carlos Slim 50
5 Jeff Bezos 45
6 Mark Zuckerberg 45
7 Larry Ellison 44
8 Michael Bloomberg 40

A report by Oxfam and Forbes in 2017 suggested that the world’s 8 richest people had as much wealth
as the poorest 3.6 billion of the world’s population.

Possible conflicts between macroeconomic aims

-It is not possible for a government to achieve all its five macroeconomic goals at once.

-There is a trade-off between these targets, if one goal is solved, a problem is created
elsewhere.
-The government has to decide which macroeconomic aim is the most important to the economy at that
particular time.

Examples of possible conflicts

i. Economic growth and low inflation
 The government may increase the level of AD to achieve economic growth.
 This may be achieved through a cut in interest rates which makes borrowing cheaper or
increasing government spending.
 An increase in AD will however force prices to go up causing demand pull inflation.
 On the other hand the government may reduce AD to control inflation but this will
cause economic decline and unemployment.
ii. Low unemployment or full employment and inflation.
 Full employment is when all the resources in an economy are being used. The economy
will be operating along the PPC.
 There is an inverse relationship between unemployment and inflation.
 When the economy expands more people get employed therefore more people have
to spend.
 This causes demand pull inflation
  On the other hand, if the government uses a contractionary fiscal policy to reduce
inflation, unemployment will rise.
iii. Economic growth and BOP.
 Economic growth leads to an increase in consumer spending and business investments.
 This will however increase the level of imports leading to a BOP deficit.
 Economic growth may cause inflation which makes exports expensive causing a BOP
deficit.
iv. Economic growth versus the protection of the environment
 Economic growth often leads to environmental problems such as land degradation,
climate change, pollution and the depletion of nonrenewable resources.
v. Economic growth and the distribution of income and wealth
 As the economy grows, there tends to be a widening gap between the rich and the poor.
 These conflicts means that the government needs to make a choice on which goal to
satisfy and which goal to sacrifice.

GOVERNMENT POLICIES
 Policies are measures taken by the government to achieve certain goals.
 These policies are divided into demand side and supply side policies.

Demand side policies

 These are policies designed to influence the level of aggregate demand in the economy.
A. Fiscal policy
 Refers to the manipulation of government expenditure and taxes in order to influence
economic activity.
 Government expenditure is also known as public expenditure.
 Government/ public expenditure refers to the spending by the government such as
unemployment benefits, provision of education, health care road and dam construction
etc.
 The government sets out the amount it plans to spend and raise in tax revenue in a
budget statement.
 A budget refers to the government’s financial plan in terms of planned revenues and
expenditures.
 Possible budget outcomes are as follows:
i. if government expenditure is greater than tax revenue: budget deficit
ii. if government expenditure is less than tax revenue: budget surplus
iii. if government expenditure is equal to tax revenue: balanced budget
Use of fiscal policy
 The fiscal policy is used either to expand or contract economic activity in order to
achieve macroeconomic objectives.

Two types of fiscal policy

i. Expansionary/ reflationary/ loose fiscal policy
 These are measures aimed at increasing AD.
 This is achieved through increasing government spending and reduction in taxes.
 A rise in government spending will increase AD leading to an increase in economic
growth and employment.
 Qq If taxes are reduced, disposable income will rise which allows people to spend
more.
 Higher consumption is likely to lead to increase in investment and economic growth.
ii. Contractionary/ deflationary /tight fiscal policy
 These are measures aimed at reducing AD.
 This is achieved through reduction in government spending and increasing taxes.
 A fall in government spending will reduce AD leading to reduced inflation.
 If taxes are increased, disposable income will fall which forces people to reduce their
spending.
 A fall in AD will force prices to go down thus curing inflation.
  An increase in AD from AD0 to AD1 will result in an increase in national income (GDP)
from Y0 to Y1 which leads to employment creation, economic growth and better
standards of living.

Other uses of fiscal policy

a) The fiscal policy is also used to redistribute income and wealth.
 This is done using a progressive tax system.
 It charges high taxes to rich in order for the government to assist the poor.
b) The fiscal policy can also be used in conjunction with supply side policies to affect the
productive capacity of an economy thus contributing to long term economic growth.

Limitations/disadvantages of fiscal policy

i. Problems with the timing ( time lags)
 It takes time for the government to identify a problem, come up with a solution and
then implement it.
 This means that wrong timing may create more problems in the economy.
 Types of time lags
a) Recognition lags- it takes time for the government to recognize problems in the
economy.
b) Administrative lags-this is the time between the identification of a problem and the
implementation of a solution.
c) Impact lags- the time between implementing a solution and the effects in an economy.
ii. Fiscal policy is associated with political problems e.g the government may reduce taxes
instead of increasing them to gain more votes during elections.
iii. Conflicting macro-economic objectives.
 Solving one problem may create another problem.
E.g expansionary fiscal policy may be used to solve unemployment but may cause
inflation.
Effects of fiscal policy on government macroeconomic aims

Fiscal policy may be used to achieve government macroeconomic aims

1. Economic growth
-an increase in government spending helps to boost investment leading to economic growth.
-lower corporation taxes can help to attract foreign direct investment (FDI) leading to economic
growth.
2. Low inflation or stable prices
-lower taxes can help to attract FDI leading to more output and lower prices.
-contractionary fiscal policy measures also help to prevent price increases.
3. Employment (low unemployment)

B. Monetary policy
 It is the manipulation of money supply, interest rates and exchange rates to influence
economic activity.
 Exchange rate is the external value of a currency ( price of one currency in terms of
another)
 Interest rate refers to the cost of borrowing or reward for saving.
 Money supply is the total amount of money circulating in the economy.

Uses of monetary policy

 Monetary policy can be used either to expand or contract economic activity.
Two types of monetary policy
a) Expansionary monetary policy
 It is also known as lose or reflationary monetary policy.
 It is achieved by increasing money supply in order to reduce interest rates.
 A fall in interest rates will increase the rate of borrowing hence increasing the level of
spending leading to an increase in AD.
 Increased AD leads to economic growth and unemployment is reduced as shown below:

b) Contractionary monetary policy

 It is also known as tight or deflationary monetary policy
 It is achieved by reducing money supply in order to increase interest rates.
 A rise in interest rates will reduce the rate of borrowing.
 This reduces the level of spending leading to a decrease in AD.
 A fall in AD leads to economic decline and inflation is reduced.
 This will however cause an increase in unemployment.

Limitations of monetary policy

i. Problems with time lags
 It takes time or the economy to react to interest rate changes.
 This reduces the effectiveness of the monetary policy or this may destabilize the
economy.
ii. Interest rate changes are not the only factor affecting the level of spending.
 Firms and consumers may be influenced by confidence levels and other factors.
iii. Higher interest rates may discourage investment leading to reduced growth.
iv. Higher interest rates may be politically sensitive so leaders may reduce interest rates to
gain votes.

C. Supply side policies.

 These are measures designed to increase AS
 These strategies aim at increasing the country’s productive capacity.
 These policies result in an outward shift of the AS curve and the PPC.

Examples of supply side policies

i. Cutting corporation tax- this may encourage investment as firms will have more funds to
invest and will keep more of the profits earned. Investment increases both AD and AS.
ii. Cutting income tax -encourages workers to increase their working hours and accept
promotion and greater responsibility increasing their productivity and AS.
iii. Reducing welfare payments- this encourages some of the unemployed to put more
effort into searching for a job hence contributing to AS.
iv. Increasing spending on education and training – this also increases workers’ skills,
productivity, mobility and flexibility hence increasing AS.
v. Trade union reform- this also increases workers’ flexibility and mobility and cut down on
the number of days lost through strikes.
vi. Privatization- firms will now operate more efficiently in the private sector due to
competition.
vii. Deregulation of markets- removing barriers to entry and laws and regulations that
increase firm’s costs of production.
viii. Subsidies- they lower a firm’s costs of production and are designed to increase a firm’s
output.
ix. Enterprise zones
 This is when the government provides incentives for firms to relocate in areas with high
unemployment.
 These incentives include tax cuts, subsidies and provision of cheaper land.
 Supply side policy measures always seek to increase AS. No government will seek to
reduce AS.
-Cut in interest rates
 -Education and training
-Free trade agreements
Reduction in welfare benefits
 In deciding whether a change in taxes, subsidies, and unemployment benefits is a fiscal
or supply side measure the intention must be considered.
 If the government is trying to influence AD then it is a fiscal policy measure, whereas if
the government is seeking to increase AS, it is a supply side policy measure.

Advantages of supply side policies

i. Improve economic growth
 Supply side policies can be used to achieve economic growth by increasing the
productive capacity of an economy.
ii. Lower inflation
 Supply side polices increase the productive potential of the economy leading to a rise in
supply.
 An increase in supply will force prices to go down.
iii. Lower unemployment
 Supply side policies help to increase national output ( GDP)
 This means that more jobs are created due to an increase in national output
iv. Improved balance of payments(B.O.P)
 Balance of payments refers to the difference between exports and imports.
 BOP position is improved because an increase in output will increase the amount of
exports.
 Moreover it will reduce prices of exported goods leading to an increase in exports.