Chapter 13 the Role of Government

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Chapter 13

The macroeconomic context 2 the role of

government

CHAPTER 13 THE ROLE OF GOVERNMENT

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CHAPTER CONTENTS

LEARNING OUTCOMES ------------------------------------------------- 149

GOVERNMENT MACROECONOMIC POLICY GOALS AND PUBLIC FINANCE ----------------------------------------------------------- 150

UNEMPLOYMENT -------------------------------------------------------- 154

INFLATION -------------------------------------------------------------- 156

MACROECONOMIC POLICY --------------------------------------------- 160



LEARNING OUTCOMES

a) Explain the main principals of public finance and macroeconomic policy.

b) Describe the impacts on organisations of potential policy responses of

government to each stage of the trade cycle.



GOVERNMENT MACROECONOMIC POLICY GOALS AND

PUBLIC FINANCE

There are four main objectives of economic policy:

1. Economic growth real growth in national income.

2. Control price inflation.

3. Full employment.

4. Balance imports & exports.

Governments are able to influence aggregate demand through use of budget

deficits and surpluses, ie through government expenditure.

The difficulty governments face is that once committed to set expenditure, either

by laws or private sector contracts, cutting expenditure may prove problematic.

Democratic governments often only have discretion over approximately 5% of total

expenditure.

Cyclical and structural deficits

Defining cyclical and structural deficits presupposes an understanding of the term

rnment revenues over

the course of a financial year, and is referred to as a budget deficit.

Cyclical deficit being the fiscal deficit being run due to the phase of the trade

cycle.

Structural deficit deficit that arises as a result of the governments assumed role

in the economy, such as running state owned industries, government failure

and emergency borrowing.

Functions of taxation

The purpose of taxation being:

Raise revenues for the government so as to fund public / merit goods.

To manage aggregate demand.

To reduce inflationary pressure on prices.

To influence consumer choices with regard to certain products.

Redistribute wealth in the economy.

Protect domestic goods.



Qualities of a good tax

Types of taxation

Complete the following table, providing two examples for each category of taxation:

INCOME EXPENDITURE CAPITAL

(Examples) (Examples) (Examples)

Taxes can also be categorised according to the percentage of income which is paid

as tax as income levels vary.

Qualities of a

good tax

Equity

Convenience

Economy

Certainty



Exercise 1

The following illustrates two individuals with substantially differing annual incomes

complete the table below so as to compare the three categories of taxation.

Type of Tax Levied At $20,000 p.a. $200,000 p.a

Regressive $2,000 flat

As a percentage of annual income -

Proportional 20%


Progressive 20% < $40k

30% > $40k


Finally, taxes may be categorised according to how they are collected: direct

taxation being paid direct to the government, compared with indirect taxation

which is collected on behalf of governments.



Setting tax rates

Within the current economic climate the overriding aim of many governments will

be to set a rate of tax that maximises tax revenue.

The Laffer Curve examines the impact on tax revenue as a result of increasing the

rate of taxation.

Discussion 1

Discuss the possible reasons as to why total tax revenue will eventually fall, as the

tax rate approaches 100%?

Tax rate (%)

Tax revenue

100



UNEMPLOYMENT

Unemployment is where not all workers willing to take a job at the present level of

wages can find work. Unemployment calculated as - (Number of unemployed /

total workforce) x 100.

Exam questions often require students to identify the various types of

unemployment that arise, therefore it is important that the following definitions are

understood.

Frictional unemployment -

Seasonal unemployment

Technological unemployment -



Cyclical unemployment -

Real wage unemployment

Voluntary unemployment -

Government employment policies

Potential measures include:

Increase government spending, thus creating jobs in the process.

Encouraging private sector development through incentives such as tax

breaks, which in turn will create more jobs.

Encouraging training, a skilled labour force will be attractive for private sector

investment.

Encouraging labour mobility.



INFLATION

Inflation refers to a sustained increase in the general price level. Inflation in the UK

is measured by reference to the consumer price index (CPI) which comprises a

As with unemployment, exam questions will often require students to identify the

different types of inflation. There are three:

Cost push inflation.

Demand pull inflation.

Quantity theory of money supply.

Cost push inflation

Cost push inflation occurs when businesses are faced with increasing production

costs and raise their prices in order to maintain profit margins. This is illustrated

below through the use of AD and AS.

Sources of cost push inflation include:

AD1

AS1

P1

Price level

Real GDP

AS2

P2

Y1 Y2



Demand pull inflation

Demand pull inflation is most likely to occur when there is little spare capacity in

the economy. An increase in AD will subsequently lead to an increase in prices.

Quantity theory of money supply

The theory that increases in the money supply will lead to increases in the price

level. The link between money and the general price level can be expressed

through the following equation (Fisher equation).

MV = PT

where:

M is the money supply

V is the velocity of circulation of money

P is the general price level

T stands for transactions and is equivalent to output

For the above equation to explain the link between money supply & inflation, V and

T must remain constant.

AD1

P1

Price level

Real GDP

LRAS 1

P2

Y1 Y2

AD2



Hyperinflation

Hyperinflation sees a rapid and continuing increase in prices resulting in the official

currency quickly losing value.

Consequences of inflation

Redistribution of wealth

Balance of payments

effects

Wage bargaining

Consumer behaviour



Inflation and unemployment

The Phillips Curve is a graphical illustration of the inverse relationship which

historically existed between the rate of wage inflation and the rate of

unemployment.

The NAIRU non-accelerating inflation rate of unemployment , is defined

as the rate of unemployment when the rate of wage inflation is stable.

Inflation Rate %

Unemployment rate %

Phillips Curve

LRPC

SRPC

NAIRU



MACROECONOMIC POLICY

Fiscal policy

Fiscal policy may be defined as the manipulation of public spending, taxation and

borrowing to a Fiscal policy is

concerned with aggregate demand (AD).

With government spending (G) and taxation (T), two policy stances may be

adopted:

Expansionary fiscal policy G > T

Or

Contractionary fiscal policy T > G

Monetary policy

Monetary policy can be used as a means towards achieving ultimate economic

objectives for inflation, the balance of trade, full employment and real economic

growth.

There are two groups of monetary policy instruments: those that affect the money

supply,

Expansionary monetary policy

Increases the supply of money and/or decrease interest rates.

Contractionary monetary policy

Reduce the supply of money and/or increase interest rates.



Discussion 2

State the impact from a rise in interest rates on the following:

Household spending

Private sector investment

Foreign funds

Exchange rates

Inflation

Bond prices

Supply side policies

Supply side theory derives from the notion that the long run aggregate supply

curve is inelastic. Therefore focussing purely on demand side policy, whilst bringing

a temporary increase in gross domestic product; ultimately leads to inflation due to

an inelastic long run aggregate supply curve with negligible impact on

unemployment.

By augmenting the overall level of supply in the economy (causing a rightward shift

in the aggregate supply curve) achieves not only increased output within the

economy, but at lower prices.

Supply-side policy focuses on deregulation as a means of increasing the supply of

goods and services in the economy.

National income National income

$ $

AD1

AD2

AS

ASs

AS ASs

AD1

Demand side policy Supply side policy



Characteristics of supply-side economics include:

Free market policies

Reduction in trade union activity

Lower tax rates

Limited role of government.

Chapter 13 the Role of Government

Documents

government expenditure

role of government chapter

government failure

percentage of income

structural deficit deficit

cyclical deficit

national income

income levels