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The government sector is one of four economic sectors, along with the household sector, the business sector, and the external sector. Unlike business, the government sector is not profit-oriented but rather provides services for the general welfare. For example, governments collect taxes to fund spending on essential services such as infrastructure, national security, and health care.
The multifaceted role of government
Governments act as multifaceted players within an economy, influencing its health and direction in numerous ways. Their responsibilities extend far beyond simply collecting taxes and providing basic services. At local, national, and international levels, governments undertake a diverse set of functions that directly and indirectly impact economic activity.
One key way governments influence the economy is through their budget and the regulations and policies they make. For example, the government makes regulations on business competition, which puts forward the practice of fair competition. In addition, the government prohibits anti-competitive practices such as price discrimination, price fixing, and dumping.
Then, the government also influences the economy by changing its revenue and expenditure budget. For example, the government changes the tax rate, where a reduction in the tax rate is expected to stimulate economic growth and vice versa. Changing the type of tax can also have an impact on the economy.
In general, the government influences the way resources are used in the economy, either directly or indirectly. Taxes, spending, and deficit financing are among the ways the government does it. In addition, the government also plays a role in:
- Supplying public goods and services
- Providing a legal and social framework
- Redistributing income
- Maintaining healthy competition in the market
- Correcting externalities
- Stabilizing the economy through its economic policies.
Local
Local governments collect some levies as revenue, as authorized by the central government, such as local taxes and levies. Another revenue comes from transfers from the central government.
Local governments then use the revenues to provide public goods and services such as street lighting, hospitals, schools, and waste collection.
National
The central government makes regulations or decisions that apply to all regions. So it’s not like local government, where the regulations are made only in their area.
In addition, the central government makes decisions about achieving macroeconomic goals such as:
- High economic growth
- Full employment
- Low inflation
- A healthy balance of payments
This is done through policies such as:
- Fiscal policy
- Monetary policy
- Supply-side policy
International
International roles involve interactions and relationships with other countries. For example, the government promotes free trade by becoming a member of a trading bloc. The government removed trade protections and trade barriers such as tariffs and quotas.
However, governments in other countries may take the opposite policy. Instead, they introduce trade barriers by imposing tariffs or import quotas. For example, the United States imposed tariffs on tires and solar panels imported from China under the Trump administration.
Government intervention also targets investment flows in addition to international trade. For example, the government introduced new regulations to increase direct investment by foreign investors. On the other hand, the government imposed restrictions on foreign portfolio investment because it was considered to disrupt macroeconomic stability.
The government also has a foreign ministry that conducts diplomatic relations with other countries, represents governments in international organizations, and negotiates treaties.
Government economic policies
In general, government economic policies are divided into two categories based on their effects on the economy. They are demand-side policies and supply-side policies. Demand-side policies comprise fiscal policy and monetary policy.
Meanwhile, supply-side policies consist of free market policies and interventionist policies. The first aims to increase the economy’s competitiveness and efficiency, while the second aims to overcome market failures.
Fiscal policy
The government changes its budget to influence the economy through revenue and expenditure. For example, the government lowers tax rates to stimulate economic growth on the revenue side. Or conversely, the government raises it to reduce inflation and economic growth.
Then, government spending can also affect the economy. For example, the government spends more revenues on building infrastructure to have a multiplier effect on the economy. Or, the government allocates it to strategic services such as education, health care, welfare, and defense.
When the government wants to foster economic growth, it can increase spending or lower taxes. We call this policy expansionary fiscal policy.
Say the government lowers the tax rate. That stimulates aggregate demand, which in turn encourages businesses to increase output. Lower taxes are expected to stimulate consumption and investment as households and businesses pay fewer taxes. Thus, they have more dollars to spend on goods and services. The increase in demand then encourages businesses to increase production.
On the other hand, the government can reduce spending or increase tax rates to moderate economic growth and inflation. This policy is known as contractionary fiscal policy.
When the economy expands and approaches full capacity, it pushes inflation up, which is called overheating. If left untreated, this condition can cause problems and lead to hyperinflation. Therefore, to overcome this problem, the government, for example, increases the tax rate.
Higher tax rates encourage households to reduce consumption. They have to pay more taxes. Thus, they have fewer dollars left to spend on goods and services because
Monetary policy
Under monetary policy, the government—in this case, the central bank as a monetary authority—affects the money supply in the economy. The three main tools for monetary policy are policy interest rates, reserve requirements, and open market operations. All three affect the money supply, which in turn affects interest rates in the economy and aggregate demand.
For example, the central bank raises interest rates, which stimulates aggregate demand and economic growth. Because interest rates are low, households and businesses can apply for loans at lower costs, prompting them to take out more to finance consumption and investment. Finally, it encourages them to increase consumption and investment.
In addition to lowering interest rates, the central bank can also lower the reserve requirement ratio and open market operations by buying government securities (buying on a large scale is called quantitative easing) to stimulate the economy to grow. Such lowering interest rates, the reserve requirement ratio, and market operations are called expansionary monetary policy or monetary easing.
Meanwhile, the central bank will raise policy interest rates to moderate aggregate demand, resulting in lower inflation and economic growth. We call it contractionary monetary policy or tight monetary policy.
In addition to policy interest rates, the central bank can tighten monetary policy by increasing the reserve requirement ratio or carry out open market operations by selling government securities.
Supply-side policy
While monetary and fiscal policies affect aggregate demand, supply-side policies seek to influence aggregate supply. It can be through:
- Privatization to increase private sector participation because it is considered more efficient.
- Deregulation to reduce bureaucracy, stimulate new business, and encourage competition in the market
- Reforming the labor market to make it more flexible, such as changing labor regulations and reducing the power of trade unions.
- Reducing unemployment benefits to encourage the active unemployed to take jobs.
- Encouraging free trade to increase trade between countries and increase competition.
- Improving education and training to improve the quality of human resources.
- Improving infrastructure and transportation to reduce logistics costs and stimulate community economic activity.
These policies are designed to promote long-term economic growth through their effect on the production capacity of an economy. They usually take longer than monetary and fiscal policies to affect the economy.
Government debt and deficits
National governments often incur debt by borrowing money to finance their spending. This creates a situation where their liabilities (what they owe) exceed their assets (what they own). A budget deficit occurs when a government spends more than it collects in revenue during a specific period. While these strategies can be used to stimulate the economy, it’s crucial to understand both the potential benefits and the associated risks.
Benefits:
- Financing public investment: Government borrowing can provide funds for infrastructure projects, education, or research and development. These investments can enhance long-term economic growth and productivity.
- Stimulating demand: Increased government spending during economic downturns can boost aggregate demand, leading to increased production and job creation.
Risks:
- Crowding out effect: High levels of government borrowing can compete with private businesses for loanable funds, potentially leading to higher interest rates. This can discourage private investment, hindering economic growth.
- Debt burden: Accumulating excessive debt can become a burden for future generations, requiring higher taxes or cuts in essential services to meet repayment obligations.
- Loss of investor confidence: High and unsustainable debt levels can erode investor confidence in the government’s ability to manage its finances, leading to higher borrowing costs and economic instability.
The decision to utilize government debt and deficits requires careful consideration of both the potential benefits and the long-term risks. Responsible fiscal policy involves striking a balance between financing essential needs and ensuring the sustainability of public finances.
