Macroeconomics The Government and the Economy EDBA 2014

Solving World Problems! Governments and the Economy Circular Flow and National Public Accounting Money and Price Level International Trade

Market Failure Market Failure – “A condition that arises when unrestrained operations in the markets yield socially undesirable outcomes” What do governments do to prevent market failure? Establishing and Enforcing the Rules of the game Market efficiency depends on people using your resources to maximize your utility. Promoting Competition Preventing firms from colluding. Regulating Natural Monopolies Natural monopolies – when one first serves the market at a lower cost than other firms. (and charges a higher price than socially optimal) Providing Public Goods

What is a Public Good A public good is a good that is non-rival and non excludable. Non-Rival – Means consumption of the good by one person does not reduce the availability of the good for others. Non Excludable – means that no one can effectively be excluded from using the product Examples: Air, Mp3 Songs, Youtube Taxes are used to pay for public goods! Excludable Non-Excludable Rivalries Private goods – Food, Clothing Cars Common Goods – Fish Stocks, timber Non-Rivalries Club Goods – Cinema, Private parks, satellite television Public goods – National TV, Defense

Externalities Dealing with Externalities Externality – a cost or benefit that falls on a third party and therefore ignored by the two parties to the market transaction. Negative externalities - pollution Positive externalities – beautification of the neighborhood Market prices do not reflect externalities Governments use the items below to discourage negative externalities and promote positive positions Taxes Subsidies Regulations

What do governments do to prevent market failure? A more equal distribution of wealth Resource markets does not guarantee a minimum level of income. TRANSFER PAYMENTS – Reflect societies attempts to provide a basic standard of living. This is also called welfare economics Minimum Wages Price Floors Price Ceilings (Rent Control) Taxes Subsidies

Minimum Wage This is relatively prevalent in Western Countries

Price Floors A price floor is a government or group imposed limit on how low a price can be charged for a product Effective Price floors are when the price floor is greater than the equilibrium price.

Price Ceiling A imposed limit of the price charged for a product Only if the price ceiling is below the equilibrium price will it be effective. Consequences of Price Ceilings Black Markets Reduction in Quality Discrimination

Taxes You can tax the firm or the consumer. Taxes change behaviour.

Subsidies Is a form of financial assistance paid to a business sector. Subsidies are given to Prevent the decline of industry Keep the cost of living down

Most important role of the government The most important role is to foster a healthy economy. Full Employment, Price Stability and Economic Growth. To do this governments use Fiscal Policy – pursuing a healthy economy by using taxation and spending is known as fiscal policy Monetary Policy – Regulating the money supply to achieve a healthy economy is called monetary policy.

Imperfect Information In competitive theory we assume all players enjoy perfect information. Imperfect information can cause the misallocation of resources and possibly market failure. Imperfect information can be caused by Misunderstanding the true costs or benefits of a product Uncertainty about costs and benefits Complexity of information Inaccurate or misleading information Addiction.

Fiscal Policy and its Instruments The use of government purchase and transfer payments, taxes and borrowing to influence aggregate economic activity such as inflation, employment and economic growth. The two main instruments of fiscal policy are Taxes Government Spending

Taxation in Sri-Lanka According to the Inland Revenue Income Tax VAT – introduced in 2002 to replace GST Standard Rate 12% Luxury 20% Economic Service Charge (does not exceed 30 million) Debits tax – 0.1% of all savings and debit accounts Betting and gambling levy Nation building tax – 3% if your turnover is over 6500000 Stamp Duty Social Responsibility Levy Turnover Tax

Taxation in Sri-Lanka Currently the tax revenue is 14% of GDP Used to be 19% in 1992 Taxes Proportional – a fixed tax rate Progressive – a tax by which the tax rate increases as the taxable base rate increases Regressive – a tax where the rate decreases as the amount subject to taxation increases.

Budget Deficits A deficit is the amount by which a sum of money falls short of the required amount. When you have a deficit what can you do You can borrow You can ask for a raise Sell some assets Spend less Governments do the same as shown above except one extra thing They can print money

Budget Deficits Continued Gt – Tt (primary deficit) G – Government Spending t – Time Frame T – All forms of taxes. Total Deficit = Spending + Interest Payment on Debt – Tax Revenue Budget Deficit Country Comparison https://www.cia.gov/library/publications/the-world-factbook/rankorder/2222rank.html The principal is that we are “investing” We borrow  We invest  We reap higher tax revenue later It eventually has to be paid back.

Multiplier Effect When the government spends 1 billion rupees worth of construction from a local company there are consequences. Higher demand from the government Increasing Employment Higher wages, higher profits Increased spending Because each rupee spent by the government raises aggregate demand by more than a rupee, government purchases are said to have a MULTIPLIER EFFECT on aggregate demand.

Crowding Out Effect There is another effect working in the opposite direction. As income rises, people choose to hold on to their money in liquid form. There is an increase in demand for money Government increases interest rates This reduces investment spending This puts downward pressure on aggregate demand. The reduction in aggregate demand that results when a fiscal expansion raises the interest rate is called the CROWDING OUT effect.

Privatization Privatization is the process of transferring owner of a business, enterprise, agency or public service from the public sector to the private sector Pros Performance Increased Efficiency Specialization Less Political interference Less corruption Accountability Profit motivation Cons Profit may not be the motive Capital Strategic and sensitive areas (defense) Essential services Job loss