The role of government | IGCSE Class 10 Economics Notes

This note covers the economic role of government at local, national and international level: why governments intervene in markets, what local and national governments do, and how governments act internationally through trade, aid, international organisations and the management of their currency.

What is the economic role of government?

A market economy, left alone, does not always produce outcomes that a society wants. Prices set by demand and supply do not automatically provide everything people need, protect the environment, or share income fairly.

Governments therefore take on an economic role in addition to the role of private firms and households.

This role can be examined at three levels. Local government deals with the economic needs of a town, district or municipality. National government sets policy for the whole country, usually through a finance ministry and a central bank.

At the international level, governments manage their country's dealings with the rest of the world, particularly trade and the exchange rate of their currency.

Each level has its own tools, and between them they pursue three broad aims: providing goods and services that markets under-supply, managing the overall performance of the economy, and regulating the behaviour of firms and individuals.

What does government do at the local level?

Local government is the layer closest to residents and firms. It typically provides local public goods such as roads, street lighting, parks and waste collection, which benefit everyone in an area whether or not they pay directly for them.

It also issues planning permission for building and development, enforces local trading standards, and runs local services such as libraries.

Definition: public good. A good or service that is non-excludable (no one can be stopped from using it) and non-rival (one person's use does not reduce another's), such as a street light or a public park.

Local government is usually funded by local taxes or rates charged on property, together with grants handed down from national government.

Because its budget and powers cover only its own area, local government cannot run macroeconomic policy; it concentrates on the direct, everyday needs of its own area, such as repairing local roads or collecting rubbish, rather than managing inflation or the exchange rate for the whole country.

What does government do at the national level?

National government sets policy for the economy as a whole. It uses fiscal policy, which means changing the levels of government spending and taxation, for example to build infrastructure, fund education and health care, or to run a budget deficit or surplus.

It also directs, or shares responsibility for, monetary policy, usually carried out by a central bank through changes in interest rates and the money supply, to pursue objectives such as low inflation, low unemployment, steady growth and a sustainable balance of payments.

Definition: fiscal policy. The use of government spending and taxation to influence the level of economic activity.

National government also provides nationwide public goods such as defence and the justice system, redistributes income through taxation and benefits, and regulates firms through competition law and consumer protection legislation so that markets work fairly.

National government is also a large employer and producer: it employs workers such as teachers, doctors and civil servants, and in some countries it owns and runs firms, called state-owned enterprises, in industries such as rail transport or energy.

A central bank or monetary authority is the national body that most directly manages a country's currency.

For example, a country's central bank usually carries out any intervention in the foreign exchange market, and in some countries it also compiles the balance of payments data, showing how a national institution carries out this economic function on behalf of the government.

What does government do at the international level?

Internationally, government decides how open the economy is to trade in goods, services and financial assets with other countries, and it chooses the system by which its foreign exchange rate is determined.

The foreign exchange rate is the price of one currency in terms of another; it links the currencies of different countries and allows comparison of international costs and prices.

Governments also build up official reserves of foreign currency, which they can use to intervene in the foreign exchange market, and they take part in international bodies such as the International Monetary Fund (IMF), which sets accounting standards used for recording a country's international transactions.

Without confidence that a currency will keep a stable purchasing power, other countries will not accept it in trade, so government action to maintain that confidence is itself part of the international role of government.

How does a government manage its exchange rate?

Under a fixed exchange rate, government fixes the exchange rate of its currency at a particular level rather than letting demand and supply determine it.

A government might, for example, fix a higher exchange rate than the market would set, to make its currency cheaper for foreigners and so encourage exports. For instance, if the market-determined rate between a domestic currency and the dollar is 50 units per dollar, the government could instead fix the exchange rate at 70 units per dollar to make its currency cheaper for foreign buyers and so encourage exports.

At a fixed rate that is above the market-clearing rate, such as 70 units per dollar when the market rate is 50, the supply of foreign currency exceeds the demand for it, and the central bank must step in to purchase the excess foreign currency to stop the exchange rate falling back towards the market rate. In this example, the central bank would need to buy up the excess dollars being supplied at 70 units per dollar.

Doing this continually builds up the central bank's holdings of foreign exchange. At a fixed rate that is below the market-clearing rate, there is instead excess demand for foreign currency, and the central bank must meet this by withdrawing foreign currency from its past reserves.

If it cannot keep doing so, a black market for the foreign currency may appear.

1. Government decides on a target exchange rate, which may differ from the rate demand and supply would set.
2. The central bank monitors whether, at that rate, there is excess supply of or excess demand for the foreign currency.
3. If there is excess supply, the central bank buys the surplus foreign currency, adding to its reserves.
4. If there is excess demand, the central bank sells foreign currency from its reserves to meet it.
5. If reserves run low and the government cannot keep meeting excess demand, the fixed rate may have to be officially changed.

When a government raises the fixed exchange rate (more units of its currency per unit of foreign currency) so that its currency buys fewer units of foreign currency, this is called a devaluation.

When a government instead lowers the fixed exchange rate (fewer units of its currency per unit of foreign currency) so that its currency buys more foreign currency, this is called a revaluation.

These official changes are distinct from depreciation and appreciation, which describe changes in the value of a currency that happen under a market-determined, floating exchange rate rather than by a government decision.

Definition: fixed exchange rate. An exchange rate system in which government sets the value of its currency against another currency at a particular level and uses its official reserves to maintain that level.

The vertical axis shows the exchange rate in units of domestic currency per dollar and the horizontal axis shows the quantity of dollars. The demand curve slopes downwards and the supply curve slopes upwards, meeting at the market rate of 50. A horizontal line at the fixed rate of 70 lies above the equilibrium, and at that rate the supply of dollars exceeds the demand for dollars by the horizontal distance marked as the surplus the central bank must buy.

How do governments act on international trade?

An open economy is one that trades with other countries in goods and services and, most often, also in financial assets. Trade widens choice, because consumers and producers can choose between domestic and foreign goods, and it lets investors choose between domestic and foreign assets.

Foreign trade influences a country's aggregate demand in two ways. When residents buy foreign goods, that spending is a leakage from the circular flow of income and reduces aggregate demand at home. Exports to foreigners are an injection into the circular flow and raise aggregate demand for goods produced within the domestic economy.

Governments therefore take deliberate decisions about how open the economy should be. A tariff is a tax on imports, and a quota is a quantitative limit on imports. Both are barriers to trade: they raise the price of foreign goods or restrict their quantity, and so protect domestic producers.

Governments also negotiate trade agreements with other countries to reduce barriers between them and so expand the market open to their exporters.

Definition: tariff. A tax imposed on imported goods, which raises their price in the domestic market and so tends to reduce the quantity imported.

Trade policy is an international role because one country's barrier affects its trading partners. A tariff that protects a domestic industry may invite retaliation, and a quota that limits imports reduces the choice available to domestic consumers.

How do governments act through aid and international organisations?

Governments also act internationally by giving foreign aid: transfers of money, goods or technical help from one government to another, or to people in another country. Aid may be given to relieve a disaster, to support health and education, or to help build roads, ports and other capital that a poorer country cannot finance itself.

Governments also join international organisations and accept shared rules. The International Monetary Fund (IMF) is one such body: it sets accounting standards used for recording a country's international transactions, and it can lend to countries in difficulty. Another is the World Trade Organization (WTO), which sets rules for trade between its member countries and helps to settle trade disputes between them.

Membership brings obligations as well as benefits. A country that accepts common standards makes its data easier for other countries to read and compare, which supports trade and lending, but it gives up some freedom to set its own rules.

Definition: foreign aid. A transfer of money, goods or technical assistance from one government to another, or to people in another country, usually to support development or relief.

Working through organisations also lets governments coordinate action that no single country could carry out alone, such as stabilising the international monetary system so that transactions between countries are reliable, or agreeing to cut greenhouse gas emissions, which affect the climate of every country.

Going beyond the syllabus

These ideas extend the unit and are not needed for the questions on it.

What is the balance of payments and why does government manage it?

The balance of payments (BoP) records the transactions in goods, services and assets between residents of a country and the rest of the world over a period, usually a year. It has two main accounts, the current account and the capital account.

The current account records trade in goods and services and transfer payments such as gifts, remittances and grants.

Within it, the trade balance is the difference between the value of exports and imports of goods, and net invisibles is the difference between the value of exports and imports of services, income and transfers.

The capital account records international transactions in assets, such as loans, shares and foreign direct investment.

The table below shows the components, using sample figures for a country's balance of payments.

A deficit on the current account means a country is a borrower from the rest of the world, and it must be financed, either by a capital account surplus (net borrowing or sale of assets) or by government running down its official reserves.

This is why government manages the balance of payments closely: a persistent deficit affects how much foreign currency is available and how much the country depends on borrowing from abroad, while a persistent surplus means the country is a net lender to other countries.

Definition: balance of payments. A record of all the transactions in goods, services and assets between the residents of one country and the rest of the world over a given period.

What are the merits of fixed and floating exchange rates?

A floating exchange rate gives government more freedom, because it does not need to hold large stocks of foreign exchange reserves: movements in the exchange rate itself automatically help to correct surpluses and deficits in the balance of payments.

A floating rate also lets a country run its monetary policy independently, since it does not have to intervene constantly to defend a particular exchange rate.

A fixed exchange rate, by contrast, can give traders and investors more certainty about future prices, which may encourage trade and investment, provided people trust that the government can maintain the fixed rate.

Government intervention in a fixed exchange rate can also be used deliberately to pursue a trade objective. For example, a government fixing its rate above the market level, at 70 units per dollar instead of a market rate of 50 units per dollar, makes its currency cheaper for foreign buyers and so could help to encourage exports, showing how a fixed rate lets government use the exchange rate itself as a policy tool.

By continuing to purchase the excess foreign currency that results from a fixed rate set above the market level, the central bank also builds up its reserves of foreign exchange, which can later be used to defend the currency or to meet other international payments, such as repaying borrowing or financing a current account deficit.

What are the limitations of fixed and floating exchange rates?

A fixed exchange rate system depends on credibility: government must be seen as able to maintain the chosen rate.

If people doubt that official reserves are adequate, they may start to expect a devaluation, and aggressive selling of the currency based on that expectation can itself force the government to devalue, which is called a speculative attack.

Maintaining a fixed rate also requires government to keep accumulating or running down reserves, which is costly and can limit how it uses monetary policy for other purposes.

A floating exchange rate has its own limitation: because the rate changes constantly with demand and supply, it creates uncertainty for traders and investors about the future value of the currency, which a fixed rate avoids.

What is a managed floating exchange rate?

Many governments today use neither a fully fixed nor a fully floating system, but a managed floating exchange rate, sometimes called dirty floating.

Here the central bank lets the exchange rate move with demand and supply most of the time, but intervenes to buy or sell foreign currency when it judges the movement to be too sharp.

What does purchasing power parity predict?

Over the long run, the purchasing power parity theory predicts that, if there are no barriers to trade such as tariffs or quotas, exchange rates between currencies should adjust so that the same product costs the same whether its price is measured in one country's currency or another's, once differences in transport cost are allowed for.

For example, if a shirt costs $8 in one country and 400 units of currency in another, the exchange rate consistent with that should be 50 units per dollar; if prices then rise by 20 per cent in the second country and 50 per cent in the first, the exchange rate consistent with equal prices becomes 40 units per dollar, so the dollar has depreciated.

This theory helps explain why currencies of countries with persistently higher inflation tend to depreciate against currencies of countries with lower inflation.

Glossary

• Open economy: An economy that trades with other countries in goods, services and, usually, financial assets.
• Public good: A good or service that is non-excludable and non-rival, so a market left alone tends to under-supply it.
• Fiscal policy: The use of government spending and taxation to influence the level of economic activity.
• Monetary policy: The use of interest rates and the money supply, usually by a central bank, to influence the economy.
• Foreign exchange rate: The price of one currency in terms of another currency.
• Fixed exchange rate: An exchange rate officially set by government and maintained using official reserves.
• Floating exchange rate: An exchange rate determined by demand and supply in the foreign exchange market, with no government intervention.
• Devaluation: An official government decision, under a fixed exchange rate system, to make the domestic currency cheaper.
• Revaluation: An official government decision, under a fixed exchange rate system, to make the domestic currency more expensive.
• Depreciation: A fall in the value of a currency under a floating exchange rate, caused by demand and supply, not a government decision.
• Appreciation: A rise in the value of a currency under a floating exchange rate, caused by demand and supply, not a government decision.
• Balance of payments: A record of transactions in goods, services and assets between a country's residents and the rest of the world.
• Current account: The part of the balance of payments recording trade in goods, services and transfer payments.
• Capital account: The part of the balance of payments recording international transactions in assets.
• Tariff: A tax on imported goods, which raises their domestic price and tends to reduce the quantity imported.

Common errors and misconceptions

• Misconception: devaluation and depreciation mean the same thing. Correct: devaluation is an official government decision under a fixed exchange rate; depreciation is a market-driven fall in value under a floating exchange rate.
• Misconception: a floating exchange rate means government has no role at all. Correct: government still decides to adopt that system, and may still intervene occasionally under managed floating.
• Misconception: a balance of payments deficit is always a sign of economic weakness. Correct: a deficit simply means the country is a net borrower for that period; it must be financed, but it is not automatically harmful.
• Misconception: the trade balance and the current account balance are the same thing. Correct: the trade balance covers only goods; the current account balance also includes services, income and transfers.
• Misconception: local government and national government carry out the same economic functions, just on a different scale. Correct: national government alone can run fiscal and monetary policy for the whole economy; local government deals mainly with local public goods and services.
• Misconception: a fixed exchange rate can be maintained indefinitely regardless of reserves. Correct: a fixed rate that is not matched by demand and supply requires continual use of official reserves, and may have to be changed if reserves run out.
• Misconception: a tariff and a quota are the same kind of barrier. Correct: a tariff is a tax on imports that raises their price, while a quota is a quantitative limit on the amount that may be imported.

Exam-style questions with model answers

Q1. Identify two ways in which a government carries out an economic role at the international level. [2 marks]

1. It sets trade policy, for example by placing a tariff (a tax on imports) or a quota (a limit on the quantity of imports) on foreign goods, or by negotiating trade agreements.
2. It gives foreign aid to other countries, or joins international organisations such as the International Monetary Fund (IMF).

Q2. Identify two levels, other than the international level, at which a government carries out an economic role. [2 marks]

1. The local level, where local government provides local public goods such as roads and waste collection.
2. The national level, where national government sets fiscal and monetary policy for the whole economy.

Q3. Explain two ways in which a national government manages the whole economy that are not available to local government. [4 marks]

1. National government can use fiscal policy, changing its total spending and taxation across the whole country.
2. Raising or cutting spending and taxes influences the level of economic activity nationally, for example to reduce unemployment or to control inflation.
3. National government, often through a central bank, can use monetary policy, changing interest rates or the money supply, to influence borrowing, spending and the exchange rate for the whole economy.
4. Local government does not have the tax base or the authority to run either of these policies for the national economy; it mainly provides local public goods funded by local rates and national grants.

Q4. A government fixes its exchange rate at a rate above the level that demand and supply would set, so there is now excess supply of foreign currency. Explain how the government could respond, and what might happen if it did not. [4 marks]

1. The central bank can respond by buying up the excess foreign currency at the fixed rate, adding it to the country's official reserves, which keeps the fixed rate in place.
2. If it keeps doing this, its reserves of foreign currency will keep growing the longer the intervention continues.
3. If the government did not intervene at all, the exchange rate would move back towards its market-determined level, and the fixed rate could not be maintained.
4. This shows that maintaining a fixed rate above the market level requires continual government intervention, not a one-off action.

Q5. Analyse the merits and limitations of a government choosing a floating exchange rate system rather than a fixed exchange rate system. [6 marks]

1. Under a floating system, movements in the exchange rate happen automatically in response to demand and supply, which helps to correct a surplus or deficit in the balance of payments without government action.
2. Government does not need to hold large stocks of official reserves, because it is not committed to defending a particular rate.
3. Government gains independence to use monetary policy for domestic objectives, such as inflation or unemployment, instead of having to set interest rates to defend the exchange rate.
4. The main limitation is that a floating rate creates uncertainty, because importers, exporters and investors cannot be sure what the exchange rate will be in future.
5. A fixed rate, by contrast, gives more certainty to trade and investment decisions, provided the government is seen as able to maintain it.
6. Overall, the choice involves a trade-off between the certainty a fixed rate offers and the flexibility and independence a floating rate offers, and this is why many governments choose a managed floating system that combines elements of both.

Q6. Discuss whether a government should use a tariff to protect a domestic industry from foreign competition. [8 marks]

1. A tariff is a tax on imports. It raises the price of foreign goods in the domestic market, so consumers switch towards the domestic substitute and domestic producers sell more.
2. This protects the incomes and jobs of workers in the protected industry, which may be important if the industry is large or concentrated in one region.
3. Protection may also be justified for a young industry that needs time to grow large enough to compete, or for an industry a country considers essential in a crisis.
4. However, the tariff raises the price consumers pay, so their real income falls and they have less to spend on other goods.
5. Domestic producers sheltered from foreign competition may become less efficient, because they face less pressure to cut costs or improve quality.
6. Other countries may retaliate with their own tariffs, so exports fall and the gains from trade are reduced for both sides.
7. On balance, a tariff may be justified for a limited period and a clearly identified industry, but a general and permanent tariff is likely to cost consumers and efficiency more than it gains.
8. The government should therefore choose a temporary, targeted tariff rather than broad protection.

Q7. Discuss whether a persistent deficit on the current account of the balance of payments should be a cause for concern for a government. [8 marks]

1. A current account deficit means the country is spending more on imports, income payments and transfers than it is earning from exports, income and transfers, so it must be financed by borrowing or by running down official reserves.
2. If the deficit is financed mainly by short-term borrowing, it could leave the country vulnerable if lenders lose confidence and withdraw funds suddenly.
3. A persistent deficit financed by running down reserves could eventually force the government to devalue a fixed exchange rate or allow a floating rate to depreciate sharply.
4. On the other hand, a deficit financed by stable, long-term capital inflows, such as foreign direct investment, may not be as concerning, because it reflects confidence in the country's economy.
5. A deficit caused by importing capital goods to build productive capacity may also be less worrying than one caused by importing consumer goods, since it can support future growth and exports.
6. A deficit may also reflect strong domestic growth, which pulls in imports while the country's own exports grow more slowly.
7. Overall, whether a current account deficit is a cause for concern depends on its size, how it is financed and whether it persists over time, rather than on its existence alone.
8. A government should therefore monitor the deficit and its financing rather than treat any deficit as a crisis.

Key takeaways

• Government carries out an economic role at local, national and international level, each with different tools and objectives.
• Local government mainly provides local public goods and services, funded by local taxes and national grants.
• National government uses fiscal policy and monetary policy to manage the whole economy's inflation, unemployment and growth.
• Internationally, government sets trade policy through tariffs, quotas and trade agreements, gives aid and joins organisations such as the IMF.
• A fixed exchange rate is set by government and defended with official reserves; a floating exchange rate is set by demand and supply.
• Devaluation and revaluation are official changes under a fixed rate; depreciation and appreciation are market-driven changes under a floating rate.
• The balance of payments records a country's transactions with the rest of the world through the current account and capital account.
• A floating exchange rate gives government more monetary independence but less certainty; a fixed rate gives more certainty but requires large reserves and credibility.

Test yourself

What is the difference between local government and national government in terms of economic role?

Local government provides local public goods and services for its own area; national government sets fiscal and monetary policy and provides public goods for the whole country.

What is a fixed exchange rate?

An exchange rate officially set by government at a particular level and maintained by using official reserves of foreign currency to buy or sell as needed.

What is the difference between devaluation and depreciation?

Devaluation is an official government decision under a fixed exchange rate; depreciation is a market-driven fall in a currency's value under a floating exchange rate.

What are the two main accounts in the balance of payments?

The current account, which records trade in goods and services and transfer payments, and the capital account, which records international transactions in assets.

Why might a floating exchange rate system give a government more independence in monetary policy?

Because the government does not have to use interest rates or reserves to defend a particular exchange rate, it can set monetary policy to pursue domestic objectives instead.

What is a speculative attack on a currency?

A situation where investors, expecting a fixed exchange rate to be devalued, sell the currency aggressively, which can force the government to devalue it.

What is the difference between a tariff and a quota?

A tariff is a tax on imports that raises their price in the domestic market; a quota is a quantitative limit on the amount of a good that may be imported.

What does a surplus on the current account mean for a country?

It means the country is a net lender to the rest of the world over that period, earning more from abroad than it spends abroad.