In everyday society governments provide such services as national defense, police, public education, firefighting services and administration of justice. So governments spend part of their revenue on these particular goods and services.
Governments finance their expenditure primarily through taxes collected from households and firms. In the UK the government takes nearly 40 per cent of national income in taxes. By taxing the rich and making transfers to the poor, the government ensures that the poor are allocated more of what is produced and the rich get correspondingly less.
We focus on government for a number of reasons. One is that taxes, government expenditures on goods and on transfers, and government regulations all affect the way private markets work. Markets free of government intervention function well in some respects and function poorly in others.
What ought to be the role of government in the economy? The following economic responsibilities are best fulfilled by government:
- Safeguarding the market system;
- Providing public goods and services;
- Dealing with externalities;
- Assisting those in need;
- Helping specific groups;
- Stabilizing the economy.
THE MIXED ECONOMY
In a mixed economy the government and private sector interact in solving economic problems. The government controls a significant share of output through taxation, transfer payments, and the provision of goods and services such as defense and the police force. It also regulates the extent to which individuals may pursue their own self-interest.
In a mixed economy the government may also be a producer of private goods such as steel or motor cars. Examples of this in the UK include nationalized industries such as steel and coal.
Most countries are mixed economies, though some are close to command economies and others are much nearer the free market economy.
Thus, we consider the economics of a market economy with absolutely minimal governmental interference. In mixed economies, most decisions are made on a decentralized basis market by market, but in every market the government presence is always important to some degree. Most people either pay substantial taxes or enjoy special benefits from tax privileges. Government regulation is everywhere; we need licenses to start businesses and clearances to sell securities that raise funds for financing them. Businesses hire labour, subject to provisions such as minimum wage laws, federal restrictions on hiring foreigners and so forth. The cars we buy have many features required by government safety regulations.
Just as market economies today are really mixed economies, the centrally planned economies do not function entirely on the principles of textbook central planning. In planning economies, central bureaucracies play an extremely important role in determining which goods are produced, in what quantities, and the prices for which they are sold. Nevertheless, market forces familiar to everyone in market economies also play an important role. For example, in many centrally planned economies, farmers work on collective or state farms but also on small private plots of land. Farmers can take the produce grown on private plots to markets and sell it at whatever prices the market will bear. Similar examples appear in market economies.
CAN INFLATION BE BENEFICIAL?
Inflation is generally defined as a persistent rise in the general price level with no corresponding rise in the output, which leads to a corresponding fall in the purchasing power of money. Inflation varies considerable in its extent and severity. Hence, the consequences for the business community differ according to circumstances. Mild inflation of a few per cent each year may pose few difficulties for business. However, hyperinflation, which entails enormously high rates of inflation, can create almost insurmountable problems for the government, business, consumers and workers.
We would be simplifying the impact of inflation on business if we suggested that all effects were unfavourable. There is a school of thought, which argues that a low and stable rate of increase in the price level can be beneficial. It believes that a steady rise in money profits produces favourable expectations and induces investment as firms seek to expand. This action expands the economy as a whole. Paradoxically, inflation can also reduce the costs of businesses in the sort run. Many enterprises incur costs, which are fixed at a particular figure for a few years. At a time when the selling price of the firm’s product, and hence its sales income, is rising this cost will be falling in real terms and thus stimulating the business.
There is a further argument that firms may be persuaded to borrow heavily in a period of inflation since the burden of repaying loans is reduced by inflation. If inflation is running annually at 10 per cent, for example, then the real value of the repayments of the loan will fall by approximately that amount each year. This may serve to encourage investment which, since it is an injection into the circular flow, will promote the level of activity. However, in these circumstances interest rates are likely to be high.
Government will accept that low rates of inflation are likely to exist in many economies. Inflation rates of 5 per cent or below are not considered to be too great a problem, especially if the competitor nations are suffering similar rates.
In spite of the above, the conclusion must be drawn that inflation is, in general, harmful to business and its environment. Indeed, many economists would contend that inflation is the fundamental evil as its presence leads to lack of competitiveness and there fore relatively high unemployment and low rates of growth. This viewpoint has gained in credence in government circles over the last few years. It is for this reason that its control has been a major objective of government economic policy throughout the 1980s and early 1990s.