Key Economic Tools

"What economic tools does the government use to manage the economy and carry out economic functions? Outline how the government carries out these functions and discuss some of the constraints the government faces in performing these functions."

The government performs many different tasks and functions in the economy and management of the economy. The government has a variety of tools, which are used in the management of the economy, but along with these tools, constraints are often placed on the government.

One of the main economic functions of governments is the reallocation of resources. The government largely uses taxation and expenditure to affect resource allocation. If the government spends large amounts on collective goods and services and welfare and it is financed by taxation then some resources will have moved out of private production and into the public sector. Also, if the government places taxes on some products and services and not on others, then this will alter prices and have an effect on demand. This would have an impact on the allocation and resources in the production of these various goods and services that have been taxed. Another way taxation can be used as a tool for the reallocation of resources is if governments use various incentives to either encourage or discourage certain types of production. Some of these incentives could include subsidies, tariffs, quotas or various tax incentives.

The government can redistribute income, which in effect can attempt to correct inequalities in the distribution of wealth and income in the economy. E.g if a government were to place higher taxes on those on higher incomes, and use funds received to provide welfare for those on lower incomes, then the spread of income is more even. This can also assist in the reduction of poverty. When the government has an income taxation system that taxes higher income earners more than lower income earners, it is called a progressive taxation system. The more income you earn, you get placed in higher tax brackets and therefore pay more tax.

Governments attempt to stabilise the economy by using both fiscal and monetary policies. Governments try to avoid major fluctuations in economic activity by using a mix of policies. Fiscal policy refers to the use of taxation and spending of a government and monetary policy refers to controlling the cost and availability of money in the economy i.e. interest rates. By using a suitable policy mix, governments are usually able to counter the effects of severe fluctuations throughout the business cycle. In a period of high inflation, the government could tighten its monetary policy through the reserve bank. If interest rates rise, this slows down the rate of economic growth by discouraging spending. This would dampen the effect of inflation. The government could use fiscal policy to slow down levels of economic activity by creating a surplus where government spending is less than taxation. Governments can also do the opposite by lowering interest rates to create higher levels of spending or lowering tax rates to do the same.

There are various constraints that are placed on governments in performing their economic functions. One of these is constitutional powers. The Australian federal government has exclusive powers regarding matters, which affect the nation as a whole e.g. defense. It also has concurrent powers in things such as taxation, which the states are also involved in. Disputes that occur over these concurrent powers can be referred onto the High Court of Australia. The High Court has the power to overturn any government legislation, which it sees as being in breach of the Australian constitution. Other matters that arise from the constitution can be put directly to the people of Australia. This is called a referendum. An example of this is the call for an Australian Republic by the Australian Republican Movement. In order for a referendum to be passed, a majority of voters and also a majority of states must pass the motion.

Another constraint placed on the Australian Government is various international agreements. The Australian government has signed various United Nations conventions dealing with things such as Human Rights, the International Law of the Sea, the Biodiversity Treaty, the Convention on Global Warming and Climate Change and the protection of the World Cultural and Natural Heritage. As well as all of these, Australia is also a member of the World Trade Organisation and various other international organisations. Australia’s government policies are developed to be consistent with the obligations and commitments to these international agreements and organisations.

The government uses many different tools to manage the economy. These include reallocation of resources, redistribution of income and using both fiscal and monetary policy. Along with these tools also come constraints on the government. Some of these are the powers of the constitution and also international agreements, which Australia is a part of.