Economic environment unit6

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Introduction to Basic Economic Theory and Concepts
The Banking Economic Systems
Pricing and Price Mechanism
Inflation
The Government and Economy
Types of Business Organizations
MODULE COVERAGE
1
International Trade and Regional Groupings

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The role of Government in the economy
• As regulator (General)
People and firms do business with each other. The government’s role is to regulate
those interactions. Some of this regulation is through general laws, like the law
of contract, which brings people together to do business. Other regulation
involves civil laws which are about outlining people’s rights and responsibilities
in relation to each other, for example the laws regarding trespass. Such laws are
usually enforced through the judicial arm of government.
Most regulation is in the form of laws passed by Parliament. These fall into two
general classes. Generic regulations cover a wide range of activities, like the Fair
Trading Act and the Companies Act, and there are also specific regulations
covering individual markets (like regulations of the banking industry). Some
specific regulations even cover a single firm.
Whatever their form or scope, regulations should have the same purpose, which is to
improve the operation of markets and make doing business easier and fairer for
all parties concerned.
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As regulator (Financial sector)
Each country has a central bank or
reserve bank which enables it to
run its financial and economic
activities in a more organized
manner. Broadly, Central banks
usually have the following
functions:
•operating monetary policy to
maintain price stability
•promoting the maintenance of a
sound and efficient financial
system
•Meeting the currency needs of
the public.
Please refer to module 1 for the
specific roles of the central bank
in the economy
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Government Policies
These are overall frameworks, principles, guidelines and statement issued/ set by the
government that shape and impact the growth rate and direction of the
economy. As we saw in earlier modules, the two policies below are used in
various combinations in an effort to direct a country's economic goals.
Fiscal policy
This refers to government actions that may influence economic activity. It’s the means
by which a government adjusts its levels of spending in order to monitor and
influence a nation's economy. Governments can influence macroeconomic
productivity levels by increasing or decreasing tax levels and public spending.
This influence, in turn, curbs inflation (generally considered to be healthy when
at a level between 2-3%), increases employment and maintains a healthy value
of money. This refers to government actions that may influence economic
activity.
Monetary policy
This refers to actions taken by the central bank, currency board or other regulatory
committee that determines the size and rate of growth of the money supply
which in turn affects interest rates. Monetary policy is maintained through
actions such as increasing the interest rate, or changing the amount of money
banks need to keep in the vault (bank reserves).
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Central banks can use the following strategies to expand or contract funds in the
banking system:
a. Buying or selling government securities in the open market.
b. Buying government securities increases the money supply by injecting cash into
the economy and helps lead to lower interest rates; selling securities decreases
the money supply by removing cash from the economy and helps to raise
interest rates.
c. Increasing or decreasing member bank reserve requirements. Higher reserve
requirements tighten the money supply; lower reserve requirements loosen the
money supply.
d. Increasing or decreasing the discount rate to member banks who borrow
reserves from them. A higher discount rate tightens money supply; a lower
discount rate loosens money supply.
e. Changing the percentage of credit required to buy securities on margin.
Functions of Government in a market economy
Economists identify five major functions of governments in market economies.
Governments provide stabilization and growth of the economy, legal and social
framework, maintain competition, provide public goods and services,
redistribute income and correct for externalities.
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A. Stabilization and Growth
Perhaps most importantly, the government guides the overall pace of employment,
and price stability. By adjusting spending and tax rates (fiscal policy) or managing
the money supply and controlling the use of credit (monetary policy); it can slow
down or speed up the economy's rate of growth and in the process, affecting the
level of prices and employment.
Recession and inflation
Generally, recessions or periods of slow economic growth and high unemployment
are viewed as the greatest of economic threats. When the danger of recession
appears, a government can strengthen the economy by spending heavily itself or
reducing taxes so that consumers would spend more, and by fostering rapid
growth in the money supply, which also encourages more spending.
Fiscal policies
A period of high inflation, high unemployment, and huge government deficits weakens
confidence in fiscal policy as a tool for regulating the overall pace of economic
activity. Therefore, if the government ensures that a country has a strong fiscal
policy in place which ensures low/reasonable inflation rates, low employment
levels and reasonable reduction in government deficits; the economy is likely to
be stable assuming other factors are doing well and this is likely to result into
economic growth.
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Monetary policies
This deals with controlling the nation's money supply through such devices as interest
rates.
Government regulations shape many aspects of business operations.
B. Maintain conducive legal and social framework
This is done by government creating laws and regulations and providing courts for the
cases that could arise. The government should therefore provide information
and services about the laws and regulations to help the economy function better.
In addition, it should define and enforce property rights and regulate contracts
made in the interest of the public.
C. Provide public goods and services
Providing goods or services that markets are unwilling or unable to provide such as
utilities like water, electricity and roads. There are costs and benefits of all
government actions.
D. Redistribute income
The government should take taxes money and giving it back out in the form of
services, safety and public goods. There should be Social Security for the public,
aid for dependent children, disabled, aged and the provision of Medicare and
Medicaid.
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E. Correcting for externalities
In economics, an externality (or transaction spillover) is a cost or benefit, not
transmitted through prices incurred by a party who did not agree to the action
causing the cost or benefit.
A benefit in this case is called a positive externality or external benefit, while a cost is
called a negative externality or external cost. In these cases in a competitive
market, prices do not reflect the full costs or benefits of producing or consuming
a product or service. Producers and consumers may either not bear all of the
costs or not reap all of the benefits of the economic activity, and too much or
too little of the good will be produced or consumed in terms of overall costs and
benefits to society.
A negative externality is an action of a product on consumers that imposes a negative
side effect on a third party; it is "social cost". Many negative externalities (also
called "external costs" or "external diseconomies") are related to the
environmental consequences of production and use. The article on
environmental economics also addresses externalities and how they may be
addressed in the context of environmental issues.
Air pollution from burning fossil fuels causes damages to crops, (historic) buildings and
public health.
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Examples of positive externalities (beneficial
externality, external benefit, external
economy, or Merit goods) include:
i. A beekeeper keeps the bees for their honey.
A side effect or externality associated with
his activity is the pollination of surrounding
crops by the bees. The value generated by
the pollination may be more important than
the value of the harvested honey.
ii. An individual planting an attractive garden
in front of his or her house may provide
benefits to others living in the area, and
even financial benefits in the form of
increased property values for all property
owners.
iii. A public organization that coordinates the
control of an infectious disease preventing
others in society from getting sick.
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