MICRO- 2.

7 Government Intervention in Microeconomics

Key Terms
1. Price controls are government regulations establishing a maximum or minimum price to be
charged for certain goods and services.
2. Price ceiling (maximum price) occurs when the government sets a price below the market
equilibrium price to encourage output and consumption.
3. Price floor (minimum price), is a form of price control that imposes a price guarantee set above
the market equilibrium price to encourage the supply of a certain good or service
4. An indirect tax is a payment taken indirectly from the consumer's income, through their
expenditure on goods and services
5. A specific tax (also known as a per-unit tax) imposes a fixed amount of tax on each product that
is sold
6. An ad valorem tax imposes a percentage tax on the value of a good or service that is sold
7. Direct provision occurs when the government directly provides or supplies goods and services
deemed to be in the best interest of the public
8. Command and Control regulation and legislation refer to the direct rules or laws governing an
activity or industry stating what is permitted and what is illegal.
9. Government failure arises when the cost of attempting to prevent or correct free market
imperfections or distortions turns out to be greater than the social cost of the original market
failure itself.

Diagrams
Price ceiling Price floor

Indirect tax Subsidy

 Impact on Markets
Government Intervention
Price Output

Price ceiling Lower than free-market equilibrium Excess demand (shortage)

Price floor Higher than free-market equilibrium Excess supply (surplus)

Indirect tax Higher than free-market equilibrium Decrease in quantity demanded

Subsidy Lower than free-market equilibrium Increase in quantity demanded

Government Impact on Stakeholders

Intervention
Consumers Firms Government

Price ceiling Increase in consumer Decreaser in producer Supply goods and

surplus surplus services to match
shortage

Price floor Decrease in consumer Increase in producer Buy Goods and Services
surplus surplus to eliminate surplus

Indirect tax Decrease in consumer Decrease in producer Increase in tax revenues

surplus; tax incidence Surplus; Lower profitability depending on PED
depends on PED

Subsidy Increase in consumer Increase in producer Increase in government

surplus; subsidy incidence Surplus; Higher spending to finance
depends on PED profitability subsidies
 MACRO- 3.1: Economic Activity, 3.2: Exchange rates

Macroeconomic Objectives Economic growth, Maintaining stable inflation, Achieving high employment,
Maintaining proper trade relations, Achieving income equality.

National Income is the value of all the goods and services produced in a country during a year, thereby
indicating the level of economic activity in the country.

Three different methods that are used to calculate National income:

1. The output method measures the actual value of all final goods and services produced within
the economy each year. This method is also referred to as national Output (O).

2. The income method measures economic activity by calculating the value of all factor incomes
earned in the economy, that is, it is the sum of wages and salaries, rent, interest, and profits. This
method is also referred to as national Income (Y).

3. The expenditure method measures economic activity by calculating the value of total spending
on newly produced goods and services during the year, comprising consumption (C), investment
(I), government (G) and net exports (X-M).
 - Consumption Expenditures (C) refers to spending by individuals and households on
goods and services. It is the single largest component of national expenditure.
- Investment Expenditure (I) refers to spending by all firms within the economy in order to
increase their capital stock and production capacity.
- Government spending (G) refers to spending of the public sector.
- Net export expenditure (X-M) refers to the difference between the country's export
earning and its import expenditure in the year.

The expenditure method is expressed by the formula GDP or AD= C+I+G+(X-M)

- The circular flow of income is a model used to explain how national income and economic
activity are determined based on the interactions of economic decision makers.
- As illustrated in this model the economic decision makers are households, firms, and the
government.
- Real flow is the flow of the actual goods or services from Firms- consumed by Households.
- Money flow is Factor payments that is received by the Households

Leakages or Withdrawals (W) take money out of the Circular flow of income. They comprise:
1. Savings (S)
2. Taxation (T)
3. Imports (M)
- W= S+T+M
Inections (J) put money into the circular flow of income. They comprise:
1. Government spending (G)
2. Export earnings (X)
3. Investment Expenditure (I)
- J= G+X+I

● GDP: The value of the final output of goods and services produced within a country in a year.
● Nominal GDP: Measures national output using current market prices i.e. the value of GDP at the
time of measurement. It measures the money value or face value of all goods and services
produced within a country for a given period of time.
● Real GDP takes account of fluctuations in prices that affect the value of Nominal National output.
The values are adjusted for inflation by using a GDP deflator.
● GDP deflator is a measure of inflation in the economy showing the extent to which prices have
changed over time. It is used to calculate real GDP.
● Real GDP per capita: The Real GDP expressed in terms of population size to determine the
value of a national income per person.
● Purchasing power parity: The exchange rate that enables residents to purchase a common
basket of goods and services in different countries.
● Gross National Income (GNI): The value of the country’s final output of all goods and services
plus net factor income earned from abroad.
- Nominal GNI= Nominal GDP + Net factor income from abroad
● Net factor income from abroad is the net income gained from other nations. The difference
between the country’s income earned from abroad and the income earned by foreign individuals
and firms in the domestic economy.
● The Business Cycle is a model that describes the fluctuations in the level of economic activity of
a country over time, thus creating a long term trend of economic growth in the economy.

-
- Boom is a phase in the Business cycle when the level of economic activity rises. It is caused by
an increase in AD.
- 1. Rising AD: Growth faster than trend
- 2. High profits
- 3. Low unemployment
- 4. High consumer & business confidence
- 5. High demand imports
- 6. Inflation
- The Peak of Business cycle occurs when Economic activity is at its highest level.
 - Recession is a phase in the business cycle that occurs when there is a fall in GDP for two
consecutive quarters.
- 1. Declining AD
- 2. High Unemployment
- 3. Fall in consumer confidence and investment
- 4. Fall in Real Estate value
- 5. Lower inflation
- 6. Low demand imports
- A Slump (Trough) occurs at the bottom of a recession in the business cycle when the AD
remains low.
- 1. Declining AD
- 2. High Unemployment
- 3. Fall in consumer confidence and investment
- 4. Fall in Real Estate value
- 5. Lower inflation
- 6. Low demand imports
- A Recovery occur when GDP starts to rise after the trough in the business cycle eventually
leading to economic growth
- 1. Rising consumer confidence
- 2. Higher house prices
- 3. Rising business confidence
- 4. Higher investment

● Potential output refers to the possible level of real GDP of an economy, as shown on its
production possibility curve, if all resources are used efficiently. It is a long run phenomenon
represented by an outward shift of the PPC.

Business Cycle VS Employment

Green GDP adjusts the country’s GDP to take account of the value of environmental degradation,
damage and destruction associated with economic growth.
Green GDP= Nominal GDP - Environmental production costs.

The better life Index is an alternative to national income as a measure of well being based on a set of 11
criteria identified by the OECD to be essential in terms of material living conditions and quality.

The happiness index is an alternative to national income as a measure of well being by considering how
information technology, governance and social norms influence communities and their level of well being.

Short Run: Government is unable to make changes to price level

Long Run: Government can make changes to price level

Aggregate Demand Aggregate Supply

The value of all goods and services demanded in Total amount of goods and services that all
the economy per time period. It is calculated as industries in the economy will produce at a given
the total amount of spending in the economy, price level
usually per year.

Reasons for Downward slope: Reasons for Upward slope:

Negative relationship between Price level and real
GDP due to
➔ Interest rate effect- PL ↑ Borrowing and
Interest ↑ GDP ↓
➔ Wealth effect- PL ↓, Value of wealth ↑,
GDP↑
➔ Exchange rate effect- PL ↑ Foreign
demand ↓- ↓ GDP
Positive relationship between Price Level and
Real output is due to Firm profitability.
➔ Increase in Price Level
➔ Increase in Profit
➔ Incentive to increase Quantity of Output
➔ Thus Y increases when PL increases
GAPS

Causes for shifts in LR

Rate of unemployment would result in a leftward shift in the LRAS and Keynesian AS curves.
Macroeconomic Objective: Low levels of Unemployment
Causes of Unemployment:
1. Cyclical Unemployment: (Demand deficient unemployment) is unemployment caused by a lack
of demand for goods and services in the economy. Caused by downturn in BC- happens during a
recession.

Deflationary gap shows the negative output gap in the economy shown by the difference between
the level of AD and that needed to achieve full employment.
2. Structural Unemployment: when the demand for labor is less than the supply for labor in an
industry.

3. Seasonal Unemployment: unemployment caused by regular and periodic changes in the derived
demand for labor at different times of the year.
4. Frictional Unemployment: transitional unemployment exists when people are temporarily
unemployed while actively searching for a new job
or waiting to start a new job.
Natural rate of Unemployment
Refers to the equilibrium rate of unemployment determined
by calculating the level of unemployment when the labor
market is in equilibrium.
Costs and consequences of unemployment:
Inflation;
Inflation is a persistent and continuous rise in general/average price levels in an economy over a period of
time.

Types of Inflation:
Cost Push: Occurs when there are changes in cost of production due to changes in costs of factors of
production

Shifts to the left

Ex.
- Wage Push- sticky wage policy
- Tax Push
- Import Push
- Exchange rates
- Profit Push

Demand Pull: Results from changes in AD factors

The consumer price index (CPI) is considered one of the most fundamental and critically important
economic indicators used to measure inflation.
Problems involved in using CPI to measure inflation:
- Substitution bias
- Introduction of new products
- Different consumption patterns
- Quality changes

The CPI tracks the average price of a basket of goods, including basic foodstuffs, housing costs, clothing,
healthcare, and recreational items.
However, it does not account for qualitative changes or substitutions of similar goods.
In addition, the CPI focuses on urban consumers and places less emphasis on the costs for people in rural
areas.

Consequences of Inflation
- Consumers lose purchasing power
- Income redistribution- regressive effect on low income groups
- Negative real interest rates
- Cost of Borrowing increases- ease of doing business decreases
- Business uncertainty
- Creditors- worse off, debtors- better off
- Wage inflation

Deflation VS Disinflation explain using diagrams

Deflation is the drop in general price levels in an economy, while disinflation occurs when price inflation
slows down temporarily.

Deflation: The continuous negative decrease in price levels

Sustainable level of Public Debt

Sri Lanka
What is a public debt
How government debt arises
How do governments borrow money?
How to measure govt debt as a share of GDP?
What are the costs of a high level of debt?

Methods of Measurement
1. Budget Deficit exists when the value of government spending exceeds the value of government
revenue per period of time.
2. National Debt refers to the sum of all the accumulated budget deficits from the previous year, the
total amount of money owed by the government to its domestic and foreign creditors.
3. Debt to GDP ratio: measured the debt of an economy as a percentage of its real GDP.
4. Austerity measures refer to cutbacks in fiscal spending inorder to repay national debt. This is
achieved by reducing government spending and raising taxation.

Phillips Curve- Mapping the relationship between Unemployment and inflation

Inflation on y-axis
Unemployment rate on x-axis
Types: Short run and Long run
SRPC
LRPS: Vertical line- independent of inflation due to constant factors

Relationship between AD changes and Phillips Curve

C+I+G+(X-M)
1. When AD increases, price levels rise, inflation increases and the unemployment rate decreases.
 2. F

Expansion of AD leads to increase in Y and P in short Run. In long run only P is affected.

Reasons for negative relationship between Inflation and Unemployment Rate:

MACROECONOMIC CONFLICTS
Conflicts between Macroeconomic Objectives
1. In wanting to achieve high economic growth, the general price level increases causing high levels
of inflation. To balance between Economic growth and Inflation, a macroeconomic policy is
required.
2. Phillips curve- Employment and Inflation are directly proportional.

Macroeconomic Policies:

1. Demand Side policies- influence AD

➔ Expansionary Monetary Policy
➔ Expansionary Fiscal Policy
➔ Contractionary Monetary Policy
➔ Contractionary Fiscal Policy
2. Supply Side Policies- influence SRAS & LRAS
➔ Expansionary Market based Policies
➔ Expansionary Interventionist
➔ Contractionary Market based Policies
➔ Contractionary Interventionist
Influence of Monetary and Fiscal Policy on AD
- Desired Spending by households and Firms determine the overall demand for Goods and Services
- When Desired spending changes, AD shifts, causing short run fluctuations on output and
employment.
- Monetary and fiscal policy are sometimes used to offset those shifts and stabilize the economy.
➔ Interest Rates- Monetary
Related to interest-rate effect.
➔ Tax Rates- Fiscal
C+I+G+(X-M)

Components of Fiscal Policy

1. Government Spending
a. Education, health care, defense, infrastructure
2. Consumption spending
a. Change in Tax changes disposable income
3. Investment spending
a. Corporate taxes and subsidies