Chapter 4 - Government and the macroeconomy

Goods and services provided by the government

Merit goods, public goods, welfare services, public services, infrastructure

Merit goods

Goods and services that have both private benefits for the user and external benefits to third parties. Merit goods tend to be under-provided by the market. Governments therefore seek to produce merit goods in order to make them affordable and accessible. Examples: education, vaccinations, health services.

Public goods

Goods that are non-excludable and non-rival. As nobody can be excluded from benefiting from the public goods once they are provided, private firms are unable to profit from producing, therefore, it is left to the government to provide these goods that are essential to the growth and development of a country. Examples: street lighting, national defense, city flood defenses.

Welfare services

Government provides these services to financially support individuals who are unable to earn enough income to cover their daily living expenses. This could be for reasons including sickness, unemployment or old age. Examples: unemployment benefits, sickness benefits, child benefits, pensions.

Public services

Services that are considered to be essential for a modern society to function effectively. They are provided by the government for the general public. Examples: police force, fire service, rubbish collection.

Infrastructure

These are essential facilities such as roads and a reliable power supply that governments spend their money on in order to facilitate economic activity within the country. Examples: roads, sanitation, power grids, transport links.

Macroeconomic aims of a government

Economic growth, full employment (low unemployment), stable prices (low inflation), balance of payments stability, redistribution of income

Economic growth

Refers to the increase in the value of goods and services produced in an economy over time. Firms increase their production —> lower unemployment —> increased incomes —> increased consumer spending —> rising living standards.

Full employment

In theory, full employment should mean that all individuals in the economy who are willing and able to work have jobs, but it is unlikely as there will always be some individuals who are in the process of finding work and moving between jobs. Full employment —> higher incomes —> increased consumer spending —> rising living standards. Higher consumer spending may also benefit the producers who are likely to receive higher profits.

Balance of payments stability

Refers to flows of money into and out of a country. Money flows into the country from the sale of exports and money flows out of the country from spending on imports. While small differences between a country’s export revenue and import expenditure are not normally of concern, large differences that persist over time can become unsustainable for a country. High demand for exports —> inflation. High spending on imports —> country has to borrow money from abroad.

Redistribution of income

Refers to the transfer of income and wealth between individuals within an economy. This helps reduce poverty in an economy. Poverty is undesirable due to the hardship and suffering it creates for individuals and their families. It is also a waste of resources as it prevents individuals from contributing to the economy to their full potential.

Fiscal policy

The use of government spending and income tax rates to achieve certain macroeconomic objectives.

Government budget

A plan of a government’s future income and expected spending over a period of time (usually a year).

Reasons for government expenditure

Provide essential public goods and services, provide merit goods, facilitate economic activity, redistribute income more equally, achieve macroeconomic objectives

Reasons for taxation

Raise tax revenue, discourage consumption of demerit goods, redistribute income, protect domestic producers

Tariff

Tax imposed on imported goods.

Income tax

A tax levied on a person’s earnings from employment (salaries, wages, etc.).

Corporation tax

A tax levied on a firm’s profits.

Excise tax

A tax levied on goods that are manufactured in a country (mostly demerit goods such as alcohol and soft drinks).

Direct tax

Tax on income.

Indirect tax

Tax on goods and services.

Progressive tax

A tax system that takes a higher proportion of income from the rich than the poor.

Proportional tax

A tax system that takes an equal proportion of income from all income earners.

Regressive tax

A tax system that takes a higher proportion of income from the poor than the rich.

Principles of good taxation

Fairness, non-distortionary, certainty, convenience, simplicity, efficiency.

Aggregate demand

Refers to the total demand for all goods and services in an economy as a whole. Aggregate formula = Consumption (C) + Investment (I) + Government spending (G) + Export revenue (X) + Import spending (M)

Decrease in taxes effect on AD

More disposable income —> increased consumer spending —> increased AD

Increase in entrepreneurship—> increased investments —> increased AD

Increase in taxes effect on AD

Decrease in disposable income —> decreased consumer spending —> decreased AD

Decrease in entrepreneurship—> decreased investment —> decreased AD

Expansionary fiscal policy

Reduction in tax and increase in government spending to boost aggregate demand.

Contractionary fiscal policy

Increase in tax and reduction in government spending to reduce aggregate demand.