How Does The Government Play A Role In The Economy?

The government sector is one of four economic sectors in addition to 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.

What is the role of the government in the economy?

The government influences the economy through its budget and the regulations and policies it makes. 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.

And in general, the role of government is carried out at three levels: local, national, and international.

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.

In addition to international trade, government intervention also targets investment flows. 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.

Then, the government also has a foreign ministry to conduct diplomatic relations with other countries. The ministry also represents governments in international organizations or in negotiating treaties.

What is the government’s economic policy?

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 is aimed at increasing the competitiveness and efficiency of the economy. Meanwhile, 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 when it wants 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. The economy is overheating. And if left untreated, the 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 the monetary policy, the government – in this case, the role played by 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 affects interest rates in the economy and aggregate demand.

For example, the central bank raises interest rates. That will stimulate 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 also tighten monetary policy by increasing the reserve requirement ratio. Or the central bank carries 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 the labor market 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.

What to read next

• Circular Flow of Income: Types and Descriptions
• Economic Actors: Types and Roles
• Macroeconomic Sector: Types, Roles
• Government Sector: Meaning, Budget, and Impact on the Economy
• Household Sector: Definition and Role in the Economy
• Business Sector: Meaning, Types of Companies
• External Sector: Its Effect on the Economy
• 4 Types of Business Sector You Need to Know
• How Does the Government Play A Role In the Economy?