Chapter 13

The macroeconomic
context 2 the role of
government

w w w . s t ud y i n t e r a c t i v e . o r g

14 2

CHAPTER 13

THE ROLE OF GOVERNMENT

CHAPTER CONTENTS
LEARNING OUTCOMES ------------------------------------------------- 144
GOVERNMENT MACROECONOMIC POLICY GOALS AND PUBLIC
FINANCE ----------------------------------------------------------- 145
UNEMPLOYMENT -------------------------------------------------------- 149
INFLATION -------------------------------------------------------------- 151
MACROECONOMIC POLICY--------------------------------------------- 155

14 3

ww w. stu dyi n t e ra cti v e .or g

CHAPTER 13

THE ROLE OF GOVERNMENT

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.

14 4

ww w. stu dyi n t e ra cti v e .or g

CHAPTER 13

THE ROLE OF GOVERNMENT

GOVERNMENT MACROECONOMIC POLICY GOALS AND

PUBLIC FINANCE
There are four main objectives of economic policy:

a) Economic growth

real growth in national income.

b) Control price inflation.

c) Full employment.

d) Balance imports & exports.

Governments are able to influence aggregate demand through use of budget

deficits and surpluses i.e. 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

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

Cyclical deficit
cycle.

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

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.

14 5

ww w. stu dyi n t e ra cti v e .or g

CHAPTER 13

THE ROLE OF GOVERNMENT

Functions of taxation
The purpose of taxation being:

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

b) To manage aggregate demand.
c) To reduce inflationary pressure on prices.
d) To influence consumer choices with regard to certain products.
e) Redistribute wealth in the economy.
f) Protect domestic goods.

Equity

Certainty

Qualities
of a
good tax

Convenience

Economy

14 6

ww w. stu dyi n t e ra cti v e .or g

CHAPTER 13

THE ROLE OF GOVERNMENT

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.

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
Regressive

Levied At

$20,000 p.a.

$200,000 p.a

$2,000 flat

As a percentage of annual income Proportional

20%

As a percentage of annual income Progressive

20% < $40k

30% > $40k

As a percentage of annual income -

Finally, taxes may be categorise 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.

14 7

ww w. stu dyi n t e ra cti v e .or g

CHAPTER 13

THE ROLE OF GOVERNMENT

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

Tax rate (%)

100

Tax revenue

DISCUSSION 1
Discuss the possible reasons as to why total tax revenue will eventually fall, as the
tax rate approaches 100%?

14 8

ww w. stu dyi n t e ra cti v e .or g

CHAPTER 13

THE ROLE OF GOVERNMENT

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 -

14 9

ww w. stu dyi n t e ra cti v e .or g

CHAPTER 13

THE ROLE OF GOVERNMENT

Cyclical unemployment -

Real wage unemployment

Voluntary unemployment -

Government employment policies

Potential measures include

a) Increase government spending, thus creating jobs in the process.

b) Encouraging private sector development through incentives such as tax

breaks, which in turn will create more jobs.

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

sector investment.

d) Encouraging labour mobility.

15 0

ww w. stu dyi n t e ra cti v e .or g

CHAPTER 13

THE ROLE OF GOVERNMENT

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
oods and services.

As with unemployment, exam questions will often require students to identify the
different types of inflation, to which there are three:

o Cost push inflation.

o Demand pull inflation.
o 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.

AS2

Price
level

AS1
P2
P1

AD1

Y2

Y1

Real GDP

Sources of cost push inflation include

15 1

ww w. stu dyi n t e ra cti v e .or g

CHAPTER 13

THE ROLE OF GOVERNMENT

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.

LRAS 1

Price
level

P2
P1

AD2
AD1
Y1

Y2

Real GDP

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!

15 2

ww w. stu dyi n t e ra cti v e .or g

CHAPTER 13

THE ROLE OF GOVERNMENT

Hyperinflation
Generally regarded as being inflation in excess of 1000% per year.

Consequences of inflation

15 3

Redistribution
of wealth

Balance of
payments
effects

Wage
bargaining

Consumer
behaviour

ww w. stu dyi n t e ra cti v e .or g

CHAPTER 13

THE ROLE OF GOVERNMENT

Inflation and unemployment

Inflation
Rate %

Phillips Curve
LRPC
NAIRU

SRPC

Unemployment
rate %

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

15 4

ww w. stu dyi n t e ra cti v e .or g

CHAPTER 13

THE ROLE OF GOVERNMENT

MACROECONOMIC POLICY

Macroeconomic
policy options

Fiscal policy

Monetary policy

Supply side
policies

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

15 5

T>G

ww w. stu dyi n t e ra cti v e .or g

CHAPTER 13

THE ROLE OF GOVERNMENT

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

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

15 6

ww w. stu dyi n t e ra cti v e .or g

CHAPTER 13

THE ROLE OF GOVERNMENT

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

Demand side policy

$

AS

AS

ASs

ASs

AD2
AD1
AD1

National income

National income

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

goods and services in the economy

Characteristics of supply side economics entail

Free market policies
Reduction in trade union activity
Lower tax rates
Limited role of government

15 7

ww w. stu dyi n t e ra cti v e .or g