Government and Economic Activity

What is the role of government in modern

economies?
Pure market Economy

Markets are allowed to fully determine prices and the allocation of resources.

Command Economy

Government has a big role:

o Determines what goods to be produced
o How these goods are to be produced
o How these goods are distributed in the economy
o Determine the prices at which these goods are to be sold

Role of the Government

To set and enforce the rules of the game or laws in any economy.
Essentially sets limits on what people can do.
Sets up a system where violators are penalized.

The system of laws that was set by the government hope to bring
about a sense of order in the Economy.

Role of the Government in a Monopolistic Market

Monopolist is likely to sell at price above and at quantities below
those that prevail in perfectly competitive markets.
It causes efficiency losses in the economy.
What would government can do?
It can intervene through regulation or taxation.

Externality
Externalities occur because economic agents have effects on each
others activities that are not reflected in market transactions
- Nicholson 1989
Externalities may not always be good or positive (e.g. smell of
Durian fruit, karaoke marathon, etc).
Externalities also apply to production (e.g. water pollution and
harvest, orchard and bee farm, etc.).

What can the government do in the presence of

externalities?
Setting up controls and taxes.
Determine the Property Rights
Determining the people who have the right to use the resources.
Once the property rights question has been addressed, we will
know who to stands to benefit from the resource.

Street Lights

Non-excludability
Occurs when it is not possible to prevent anyone
from consuming a good or using a resource.

Non-Rivalry
Occurs when people can use a good or resource at
no extra cost.

Public Goods
Goods and services that exhibits the properties of non-excludability
and non-rivalry.

Who is going to pay for the construction of public goods?

Government intervention takes place through raising funds either through
taxation or some other means.

where does government

get its money?
How does it spends
its money?

The Budget of the Philippine

Government
The Budget of the Philippine Government, 20052008

Item

2005

2006

2007

2008

Revenues
(billion PHP)

816.2

979.6

1,137.0

1,202.0

Expenditures
(billion PHP)

962.9

1,044.4

1,149.0

1,271.0

Net
Budgetary
Position

-146.8

-64.8

-12.4

-68.1

Source: NSCB

Net Budgetary Position

Total revenue minus Total spending.
Budget Surplus
Revenues exceed Spending.

Budget Deficit
Spending exceeds Revenue.

Two Categories of Government

Earnings

Tax Revenues
It refers to the payments made to the government by economic agents that are
based on earnings, ownership of assets, and transactions.
These are mandatory with corresponding fines and penalties for the failure to
make payments on time.
Non-tax Revenues
It represent the National governments earnings from its services to the public, capital
and grants.

Revenues of the Philippine National Government, 2005-2007 (in percent

share)

Item

2005

2006

2007

Tax Revenues

86.5

87.8

82.1

Taxes on net income and profits

39.6

38.5

37.6

Taxes on property

0.1

0.1

0.1

Taxes on goods and services

22.5

24.2

21.2

Taxes on international trade and

transaction

19.0

20.3

18.5

Other taxes

5.2

4.7

4.7

Non-tax revenue

13.5

12.2

17.9
Source: NSCB

What does the

government do with its
money?

Item
Social Services

Expenditures of the Philippine National Government by sector, 20062006

2007
2008
2008 (in
percent share)
27.0
27.7
30.8

Economic Services

21.2

25.4

24.4

Defense

4.9

5.4

5.0

General Public
Services

17.1

17.5

16.9

Net Lending

0.0

0.8

1.0

Debt Service

29.7

23.2

22.0

Source: NSCB

 Social Services
Funds allocated for education, health, social
security, housing, and land distribution.
The biggest share went to Education, Culture, and
Manpower Development.

Economic Services
Includes spending on agriculture, agrarian reform,
natural resources, trade and industry, tourism,
power and energy, roads, communication, and
other transport.

Debt services
It represents the interests on debts that the
national government owes domestic and foreign
institutions.

Government and Income

Determination
Income Taxes (T)
Disposable Income (YD)

YD = Y T
AE = C + I + G
Y = C + I + G

Legend:
YD = Disposable Income
Y = Income
T = Taxes
AE = Aggregate Expenditure
C = Consumption
I = Investment
G = Government Spending

Y
500
600
700
800
900
1000
1100
1200
1300
1400
1500
1600
1700

T
100
100
100
100
100
100
100
100
100
100
100
100
100

YD
400
500
600
700
800
900
1000
1100
1200
1300
1400
1500
1600

C
420
500
580
660
740
820
900
980
1060
1140
1220
1300
1380

I
100
100
100
100
100
100
100
100
100
100
100
100
100

G
100
100
100
100
100
100
100
100
100
100
100
100
100

AE
620
700
780
860
940
1020
1100
1180
1260
1340
1420
1500
1580

FISCAL POLICY
It refers to the use of spending and taxation
by the government to influence the level of
economic activity.
1. Expansionary Fiscal Policy
The intent of the government is to raise the level of economic
activity or income.
It includes increase in government spending or reduction in
income taxes.

2. Contractionary Fiscal Policy

Include a decrease in government spending and/or increase in
income taxes.

Why does an increase in government spending

lead to an increase in equilibrium income?

Higher government spending raises AE.

Higher income taxes reduces consumption
spending, in turn reduces AE.

How large is the change in

equilibrium income when G or T
change?
It will depend on the size of a multiplier.

Two multipliers to be considered:

1.Government spending
2.Income taxes

Inflationary and Deflationary Gaps

Full-employment level of income (Yf)
Denotes the maximum amount that the
economy can produce if it uses all of its
resources.
This relates to the level of output wherein all
of the available labor and resources are
being used by firms in production.

1. Deflationary Gap
2. Inflationary Gap

 Deflationary Gap
Aggregate expenditure is lower than income
Equilibrium income is below full employment level, this means
the economy is not using all the resources.
If it is using all its resources, these resources are not being
utilized in their productive capacity.

Inflationary Gap
The equilibrium level of income is greater than the full
employment level of income

OPEN ECONOMY
MACROECONOMICS

Balance of Payments (BOP)

Provides a summary of the transactions between
residents of an economy and the rest of the world.
It presents information on transfer payments and income
flows.

Basic Principles
Resident
It refers to the people, firms, government, and
other institutions that are based in the country.

Standard Accounting Principle

1. Credit
Items represent payments of non-residents to residents.
The inflow of payment to a country.

2. Debit
Items represent payments of residents to non-residents.
The outflow of payment to a country.

Double-entry bookkeeping
It means that each transaction is recorded as a debit and credit
item.
Every transaction has two sides.

The implication of double-entry bookkeeping is that the sum of the

debit items must always equal the sum of the credit items.
The BOP accounts must always balance.

Components of the BOP

Item (in million
US dollar)

2004

2005

2006

2007

Current
Account (CA)

1,628

1,984

5,347

6,301

Capital and
Financial
Account (KA)

-2,630

2,229

20

2,889

Net
Unclassified
Items (NUI)

-278

-1,803

-1,598

-633

Overall BOP
Position

-280

2,410

3,769

8,557

Net Change in
Reserve Assets
(NCRA)

-280

-2,410

-3,769

-8,557

Current Account (CA)

Current Account Surplus
Positive values for a component depict a situation in
which the credits exceed the debits whereas negative
values represent the reserve.

Current Account Deficit

The values are negative

BOP Position
CA + KA + NUI + NCRA = 0
BOP Surplus = Positive Value
BOP Deficit = Negative Value

Net Change in Reserve Assets

It represents changes in the assets of the monetary authorities that
can be used for international transactions.
A positive entry in this classification implies a fall in the claims of
Philippine monetary authorities on non-residents.

Exchange Rate
It is the price of foreign currency.
It indicates how many pesos are needed to buy a unit of
foreign currency.
Devaluation or Depreciation
An increase in the price of foreign exchange
It is used when the country has a fixed exchange rate regime

Appreciation or Revaluation
A Decline in the price of a foreign exchange
It is use in a economy that has a flexible exchange rate regime

 Exchange Rate Index

This variable is the weighted zverage of bilateral exchange
rates.

Bilateral exchange rate

It is the price of a foreign currency in terms of another
countrys currency.

Fixed and Flexible Exchange Rates

1.Fixed exchange rate regime
In such a system, the government through the central bank establishes a
narrow band or a specific value for the exchange rate of the country against
other currencies.

2.Flexible or floating exchange rate regimes

The government allows the exchange rate to be determined by market forces.

3.Managed floats
Combination f fixed and flexible exchange rate regimes.
This system involves government intervention in the foreign exchange
markets in order to influence the exchange rate.

Income Determination in an Open

Economy

AE = C + I + G + X
M

YD

AE

500

100

400

420

100

100

100

100

620

600

100

500

500

100

100

100

100

700

700

100

600

580

100

100

100

100

780

800

100

700

660

100

100

100

100

860

900

100

800

740

100

100

100

100

940

1000

100

900

820

100

100

100

100

1020

1100

100

1000

900

100

100

100

100

1100

1200

100

1100

980

100

100

100

100

1180

1300

100

1200

1060

100

100

100

100

1260

1400

100

1300

1140

100

100

100

100

1340

1500

100

1400

1220

100

100

100

100

1420

1600

100

1500

1300

100

100

100

100

1500

1700

100

1600

1380

100

100

100

100

1580

1800

100

1700

1460

100

100

100

100

1660

1900

100

1800

1540

100

100

100

100

1740

2000

100

1900

1620

100

100

100

100

1820

2100

100

2000

1700

100

100

100

100

1900