4.1 – 4.

2 – The Macroeconomic Aims

of Government

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 macroeconomy 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:
 fall in employment, incomes and living standards of the

people
 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
 fall in the revenues and profits of firms

 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:
 reduces people’s purchasing powers as people will be

able to buy less with the money they have now than
before
 causes hardship for the poor

 increases business costs especially as workers will

demand higher wages to support their livelihood

 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:
 the total national output (goods produced) will fall

 government will have to give out welfare payments

(unemployment benefits) to the unemployed, increasing

public expenditure while income taxes fall – causing a
budget deficit
 large unemployment causes public unrest and anger

towards the government.

 Balance of Payments Stability: economies export (sell)
many of their products to overseas residents, and receive
income and investment from abroad; they
also import (buy) goods and services from other
economies, and make investments in other countries.
These are recorded in a country’s Balance of Payments
(BoP).
Exports > Imports = Surplus in BoP
Exports < Imports = Deficit in BoP
 All economies try to balance this inflow and outflow of
international trade and payments and try to avoid any
deficits because:
 if it exports too little and imports too much, the

economy may run out of foreign currency to buy further

imports
 a BoP deficit causes the value of its currency to fall

against other foreign currencies and make imports more

expensive to buy, while a BoP surplus causes its
currency to rise against other foreign currencies and
make its exports more expensive in the international
market.
 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:
 widening inequality means higher levels of poverty

 poverty and hardship restricts the economy from

reaching its maximum productive capacity.

Conflict of Macroeconomic Aims

When a policy is introduced to achieve one
macroeconomic aim, it tends to conflict with one or more
other aims. In other words, as one aim is achieved,
another aim is undone. Let’s look at some conflicts of
government macroeconomic aims.
Full Employment v/s Price Stability
Low rates of unemployment will boost incomes of
businesses and workers. This rise in incomes, mean higher
demand and consumption in the economy, which causes
firms to raise their prices – resulting in inflation. This is
probably the most prominent policy conflict in the study
of Economics.
Economic Growth & Full Employment v/s BoP Stability
Once again, as incomes rise due to economic growth and
low unemployment, people will import more foreign
products and consume relatively less domestic products.
This will cause a rise in imports relative to exports and a
deficit may arise in the balance of payments.
Economic Growth v/s Full Employment
In the long run, when economic growth is continuous,
firms may start investing in more capital
(machinery/equipment). More capital-intensive
production will make a lot of people unemployed.

4.3 – Fiscal Policy
Budget: a financial statement showing the forecasted
government revenue and expenditure in the coming fiscal
year. It lays out the amount the government expects to
receive as revenue in taxes and other incomes and how
and where it will use this revenue to finance its various
spending endeavours. Governments aim for its budgets to
be balanced.
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 defence 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 defence,
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
labour 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.
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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.
Classification of Taxes
 Taxes can be classifies into direct or indirect and
progressive, regressive or proportional.

Direct Taxes are taxes on incomes. The burden of tax

payment falls directly on the person or individual
responsible for paying it.
 Income tax: paid from an individual’s income. Disposable
income is the income left after deducting income tax from
it. When income tax rise, there is little disposable income
to spend on goods and services, so firms will face lower
demand and sales, and will cut production, increasing
unemployment. Lower income taxes will encourage more
spending and thus higher production.
 Corporate Tax: tax paid on a company’s profits. When the
corporate tax rate is increased, businesses will have lower
profits left over to put back into the business and will
thus find it hard to expand and produce more. It will also
cause shareholders/owners to receive lower
dividends/returns for their investments. This will
discourage people from investing in businesses and
economic growth could slow down. Reducing
corporate tax will encourage more production and
investment.
 Capital gains tax: taxes on any profits or gains that
arise from the sale of assets held for more than a year.
 Inheritance tax: tax levied on inherited wealth.
 Property tax: tax levied on property/land.
Advantages:
 High revenue: as all people above a certain income level
have to pay income taxes, the revenue from this tax is
very high.
 Can reduce inequalities in income and wealth: as they are
progressive in nature – heavier taxes on the rich than the
poor- they help in reducing income inequality.
Disadvantages:

 Reduces work incentives: people may rather stay

unemployed (and receive govt. unemployment benefits)
rather than be employed if it means they would have to
pay a high amount of tax. Those already employed may
not work productively, since for any extra income they
make, the more tax they will have to pay.
 Reduces enterprise incentives: corporate taxes may
demotivate entrepreneurs to set up new firms, as a good
part of the profits they make will have to be given as tax.
 Tax evasion: a lot of people find legal loopholes and
escape having to pay any tax. Thus tax revenue falls and
the govt. has to use more resources to catch those who
evade taxes.
Indirect Taxes are taxes on goods and services sold. It is
added to the prices of goods and services and it is paid
while purchasing the good or service. It is called indirect
because it indirectly takes money as tax from consumer
expenditure. Some examples are:
 GST/VAT: these are included in the price of goods and
services. Increasing these indirect taxes will increase the
prices of goods and services and reduce demand and in
turn profits. Reducing these taxes will increase demand.
 Customs duty: includes import and export tariffs on goods
and services flowing between countries. Increasing tariffs
will reduce demand for the products.
 Excise Duty: tax on demerit goods like alcohol and
tobacco, to reduce its demand.
Advantages:

 Cost-effective: the cost of collecting indirect taxes is low

compared to collecting direct taxes.
 Expanded tax-base: directs taxes are paid by those who
make a good income, but indirect taxes are paid by all
people (young, old, unemployed etc.) who consume goods
and services, so there is a larger tax base.
 Can achieve specific aims: for example, excise duty (tax on
demerit goods) can discourage the consumption of
harmful goods; similarly, higher and lower taxes on
particular products can influence their consumption.
 Flexible: indirect tax rates are easier and quicker to
alter/change than direct tax rates. Thus their effects are
immediate in an economy.
Disadvantages:

 Inflationary: The prices of products will increase when

indirect taxes are added to it, causing inflation.
 Regressive: since all people pay the same amount of
money, irrespective of their income levels, the tax will fall
heavily on the poor than the rich as it takes more
proportion of their income.
 Tax evasion: high tariffs on imported goods or excise duty
on demerit goods can encourage illegal smuggling of the
good.
Progressive Taxes are those taxes which burdens the rich
more than the poor, in that the rate of taxation increases
as incomes increase. An income tax is the perfect example
of progressive taxation. The more income you earn, the
more proportion of the income you have to pay in taxes,
as defined by income tax brackets.
For example, a person earning above $100,000 a month
will have to pay a tax rate of 20%, while a person earning
above $200,000 a month will have to pay a tax rate of
25%.
Regressive Taxes are those taxes which burden the poor
more than the rich, in that the rate of taxation falls as
incomes increase. An indirect tax like GST is an example
of a regressive tax because everyone has to pay the same
tax when they are paying for the product, rich or poor.
For example, suppose the GST on a kilo of rice is $1; for a
person who earns $500 dollars a month, this tax will
amount to 0.2% of his income, while for a richer person
who earns $50,000 a month, this tax will amount of just
0.002% of his income. The burden on the poor is higher
than on the rich, making its regressive.
Proportional Taxes are those taxes which burden the poor
and rich equally, in that the rate of taxation remains
equal as incomes rise or fall. An example is corporate tax.
All companies have to pay the same proportion of their
profits in tax.
 For example, if the corporate tax is 30%, then whatever
the profits of two companies, they both will have to pay
30% of their profits in corporate tax.

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.
Impacts of taxation
Taxes can have various direct impacts on consumers,
producers, government and thus, the entire economy.
 The main purpose of tax is to raise income for the
government which can lead to higher spending on health
care and education. The impact depends on what the
government spends the money on. For example, whether it
is used to fund infrastructure projects or to fund the
government’s debt repayment.
 Consumers will have less disposable income to
spend after income tax has been deducted. This is likely to
lead to lower levels of spending and saving. However, if
the government spends the tax revenue in effective ways
to boost demand, it shouldn’t affect the economy.
 Higher income tax reduces disposable income and
can reduce the incentive to work. Workers may be less
willing to work overtime or might leave the labour
market altogether. However, there are two conflicting
effects of higher tax:
 Substitution effect: higher tax leads to lower disposable

income, and work becomes relatively less attractive

than leisure – workers will prefer to work less.
 Income effect: if higher tax leads to lower disposable

income, then a worker may feel the need to work longer

hours to maintain his desired level of income – workers
feel the need to work longer to earn more.
 The impact of tax then depends on which effect is

greater. If the substitution effect is greater, then people

will work less, but if income effect is greater, people
will work more
 Producers will have less incentive to produce if the
corporate taxes are too high. Private firm aim on making
profits, and if a major chunk of their profits are eaten
away by taxes, they might not bother producing more and
might decide to close shop.
Fiscal 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.

4.4 – 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

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.

4.5 – Supply-side Policy

Supply side policies are microeconomic policies aimed at

increasing supply and productivity in the economy, to
enable long-term economic growth. Some of these policies
include:
 Public sector investments: investments in infrastructure
such as transport and communication can greatly help the
economy by making the flow of resources quick and easy,
and facilitate faster growth.
 Improving education and vocational training: the
government can invest in education and skills training to
improve the quality and quantity of labour to increase
productivity.
 Spending on health: accessible, affordable and good
quality health services will improve the health of the
population, helping reduce the hours lost to illnesses and
increasing productivity.
 Investment on housing: as more housing spaces are built,
the geographical mobility of the population will increase,
helping increase output.
 Privatization: transferring some public corporations to
private ownership will increase efficiency and increase
output, as the private sector has a profit-motive absent in
public sector.
 Income tax cuts: reducing income tax will increase
people’s willingness to work more and earn more, helping
increase the supply in the economy.
 Subsidies are financial grants made to industries that
need it. More subsidies mean more money for producers to
produce more, thereby increasing supply.
 Deregulation: removing or easing the laws and
regulations required to start and run businesses so they
can operate and produce more output with reduced costs
and hassle, encouraging investments.
 Removing trade barriers: the govt. can reduce or withdraw
import duties, quotas etc. on imports so that more
resources, goods and services may be imported to increase
productivity and efficiency in the domestic economy. It
can also reduce export duties to increase export of
resources, goods and services to other nations, thereby
encouraging domestic firms to increase production.
 Labour market reforms: making laws that would reduce
trade union powers would reduce business costs and
increase output. Minimum wages could be reduced or done
away with to allow more jobs to be created. Welfare
payments like unemployment benefits could be reduced so
that more people would be motivated to look for jobs
rather than rely on the benefits alone to live. These will
not only increase the incentive to work but also increase
the incentive to invest.
For example, India, in the early 1990’s undertook massive
privatisation, liberalisation and deregulation measures;
abolishing its heavy licensing and red tape policies,
allowing private firms to easily enter the market and
operate, and opening up its economy to foreign trade by
reducing the excessive trade tariffs and regulations. This
led to a period of high economic growth and helped India
become the emerging economy it is today.

Supply-side policies have the direct effect of

increasing economic growth as the productive capacity of
the economy is realised. In doing so, it can also create
more job opportunities and help reduce unemployment.
Trade reforms will also enable to it to improve its balance
of payments.
However, the reliance on public expenditure and tax cuts
mean that the government may run large budget deficits.
Deregulation and privatisation will also reduce
government intervention in the economy, which may
prompt market failure.