1

08 : Investigates the Type of Intervention of
the Government to Achieve Macroeconomic
Objectives.
• 8.1 Logically represents the reasons for market
failure.
• 8.2 Examines the effects of externalities on
market failure.
• 8.3 Investigates the role of the government in a
market economy.
• 8.4 Investigates the use of Fiscal policy to achieve
macro economic objectives.
• 8.5 Investigates the tax system as a major source
of government revenue.
2

• 8.6 Reveals recent changes in the
composition of government expenditure.
• 8.7 Analytically investigates economic
effects of government budgetary policies.
• 8.8 Investigates the government budget
and its economic effects.
• 8.9 Investigates the composition and
trends of public debt in Sri Lanka.
• 8.10 Analyses economic effects of supply
promotion policies of government.
3

The Failure of the Market System
• The term market failure describes any market
performance that is judged to be less good than the best
possible performance.
• In other words. Market failure means that the best
attainable outcome has not been achieved; it ones not
mean that nothing good has happened.
• The phrase market failure applies to 2 quite different
sets of circumstances. One is the failure of the market
system to achieve efficiency in the allocation of societies
resources. The other is the failure of the market system
to serve social goals other than efficiency, such as
achieving desired distribution of income or preserving
our value systems.
4

Failure to Achieve Efficiency
• There are five broad types of phenomenon
that led to inefficient market outcomes,
I. Imperfect Competition.
II. Externalities.
III. Absence of Property Rights.
IV. Public Goods.
V. Imperfect Information.
• Now we will examine each respectively.
5

Imperfect Competition.
• Economic efficiency is likely o be present in a market where
there are many buyers and sellers. But in many markets ,
there are either only a few buyers or a fewer sellers. In the
railway industry, for instance most travelers have no choice
about which company to use on a particular journey. In the
water industry, households are forced to buy their water from
one company. In Sri Lanka soap and detergent powder
market, may be 1 firm dominate the sales.
• On the other hand , the defense industry, the Sri Lankan
government is the only buyer of those goods and services.
• Trade unions would like to be in a position where only union
members work in a place of work. Where there is imperfect
competition, there is likely to be market failure.
6

• Firms which dominate their markets, for
instance, will attempt to charge high
prices in order to make greater profit. But
they can only do this by restricting supply
to the market, denying customers the
ability to buy as much competitive.
• This leads to allocative inefficiency. Trade
can push up costs to firms if they are
successful in getting higher wages for their
members than the market rate. This leads
to productive inefficiency.
7

Allocative Inefficiency of Monopoly
8
0
Qm Q0
MR
D
MC (Monopoly) = S (Competition)
P0
Pm
Em
Price
Quantity
Competitive Price
5
6 1
2
7

• Monopoly is allocatively inefficient because it
produces less than the competitive output and
thus does not maximize the sum of consumers
and producers surplus.
• If this market were perfectly competitive, price
would be Po, output would be Qo, and
consumers surplus would be 1, 5 and 6. when
the industry is monopolized, price rise to Pm
and consumers surplus falls to 5. consumers
lose area would be 1, because that output is
not produced. They lose area 6, because the
price rise has transferred it to monopolist.
9

• Producers surplus in a competitive equilibrium would
be the sum of 7 and 2. when the market is monopolized
and price rises to Pm, the surplus area 2 is lost, because
the output is not produced.
• However the monopolists gains area 6 from
consumers.(6 is greater than 2, because Pm maximizes
the profit). While 6 is transferred from consumers to
producers surplus by the price rise, areas 1 and 2 are
lost. They called as deadweight loss resulting from
monopoly.
• For all output between Qm and Qo, the value of the
output to consumers, given by D, exceeds the cost of
production, given by MC. Thus, failure to produce this
output reduces consumers plus producers surplus.
10

Externalities
• If the market system to work well, it is important
that the people who make economic decisions are
those who are affected by those decisions. A
transaction between a supplier and a consumer
for a product needs only to affect the supplier and
consumer involved. As long as this is the case,
then both sides will act only so long as both feel
that they will benefit from any action-all is well in
the market.
• However, a problem could clearly arise if someone else,
not party to the economic decisions, is affected by that
decisions, this is the economic concept of externality. 11

• An externality is said to arise if a 3rd
party (someone not directly involved)
is affected by the decisions and
actions of others. Example – if you
decide to shout loudly to your friend
in pubic, then others (3rd parties) not
involved in making that decisions are
affected by the assault on other ear
drums.
12

An “externality occurs if
privet production or
consumption of a
product imposes
involuntary economic
costs or benefits on
others.” 13

Privet & Social Costs
• There are 2 costs involved in producing goods and
services. Eg. Electricity. One is internal costs, such as
for purchasing land, labour, capital and fuel. The
other is an external cost, such as the cost of
pollution damages to the community. The social
costs of producing electric power are sum of the 2
costs mentioned above.
• Internal costs are the opportunity costs a firm or
consumer incurs by producing or consuming a good.
External costs are the costs borne by others
(external to the firm or consumer) because a good
produced or consumed.
• The social costs of production are the privet costs
plus the external costs.
14

Privet & Social Benefits
• Similarly, the social benefits of consuming
my stereo (speakers) are sum of the
internal, or privet, benefits plus the
external benefits (or minus the external
costs) to my neighbor.
• The social benefits of consumption are the
privet benefits plus the external benefits.
The privet benefits are those that mount
up solely to the decision maker.
15

Externalities of Consumption
• Benefits or losses born to an external party due
to a consumption activity is identified as
externalities of consumption
Examples of positive externalities of consumption
are;
• educational T. V. programmes
Examples of negative externalities of consumption
are;
• collection of garbage
• emission of smoke (fumes) from vehicles.
16

Externalities of Production
• Benefits or losses borne by an external party
due to a production activity is identified as
externalities of production.
Examples of positive externalities of production
• Research focused on new technology
• Beautiful gardens
Examples of negative externalities of production
are;
• Industrial activities that burn fossil fuels.
• Industrial activities that deplete the ozone layer.17

Socially Optimum Level of Output and
Market Failures.
• If MSB > MSC, then it is said to be socially efficient to produce more (or
to consume) more. On the other hand, if MSC > MSB, then it is socially
efficient to produce (or consume) less. It follows, therefore, that if MSB
= MSC, then the current level is optimum (socially equilibrium).
• Hence, the socially optimum level of output occurs where
MSB = MSC.
• However, in the real world, the market rarely leads to social efficiency.
The Marginal Social Benefit of most goods and services do not equal
the Marginal Social Cost. This is due to externalities, whether adverse or
beneficial, which cause market failure because they lead to allocation of
resources that are non-optimal from the society's point of view. As
noted, the price system considers only private costs and private
benefits, and ignores any external costs and benefit. Hence, private
producers produce too much of commodities that generate harmful
externalities because they bear none of the costs suffered by others. In
other words, external costs result in a level of output greater than the
social optimum. This can be illustrated as follows:
18

19

• The MPC curve represents the supply curve of the
industry, and assumes no external benefit, MSB is
also the MPB and the demand curve for the
industry. As the private producers reaches
equilibrium where Demand = Supply (consider only
their private costs and private benefits), the
equilibrium output of the industry id thus 0QE.
MSC lies above MPC as MSC includes both MPC
and MEC.
• The socially optimum output would be 0Qs, where
MSB = MSC. Thus, in terms of socially efficiency,
there is an overproduction of goods which
generate negative externalities. By summing the
excess of MSB and MSC for the units between Qs
and Qe, a monetary measure of the welfare loss to
society is occurred (shaded area).
20

• In the same sense, activities which generate positive
externalities can also bring welfare loss. Private producers
will tend to produce too little of commodities that
generate beneficial externalities because they bear all the
costs, while others reap part of the benefits. This is
illustrated as follows:
21

• The MSB is greater than the MPB since there are
external benefits. The socially optimum level of output
is OQs which is above the equilibrium output that would
occur in an "uncorrected' free market, 0QE.
• In other words, when there are positive externalities,
there is a tendency for underproduction of the product
in question. The shaded area shows the welfare loss
brought by underproduction.
• From the above expose, it can be deduced that
whenever there are external benefits, there will be too
little produced or consumed. On the other hand,
whenever, there are external costs, there will be too
much produced or consumed. The market will not
equate marginal social benefit and marginal social cost.
22

Government Intervention to Deal with
Externalities
• When there are imperfections in the market, social efficiency will not be
achieved. Marginal social benefit will not equal marginal social cost. A
different level of output would be more desirable. Hence, the
government has a number of instruments it can use to change the way
markets operate. These include taxes, subsidies, laws and regulatory
bodies. The more efficient method to correct these imperfections is
taxes and subsidies.
• Essentially the approach is to tax those goods or activities where the
market produces too much, and subsidize those where the market
produces too little. The government should impose a tax on each unit of
output, where the amount of tax is equal to the amount of pollution
(MEC). Hence, the externality will be internalized by the imposition of
the tax. This means the government will make the externality to enter
into the firm's own calculations of its private costs and benefits. As a
result, output would be reduced to the desired level. Assume, for
example, that a chemical plant emits smoke and thus pollutes the
atmosphere. This creates external costs for the people who breathe in
the smoke. This can be illustrated as follows: 23

24

• The firm produces output 0QE where MPC = MPB
(demand = supply), and in doing so, it takes no
account of the external pollution costs it imposes on
society. If the government imposes a tax on
production equal to the Marginal pollution cost
(MEC), it will effectively internalize the externality.
• The firm will have to pay an amount equal to the
external costs it creates. It will, therefore, now
maximize profit at OQs, which is the socially
optimum output where MSB = MSC. Similarly, in the
case of positive externality, the government has to
grant subsidies equal to the MEB. This can be
illustrated as follows:
25

26

• Consider the demand and supply conditions
for education. The market reaches equilibrium
at output OQE. The government examines that
there involves a positive externality. Hence,
the government has to encourage the
consumption of such good so that the whole
society will benefit and grant subsidies on
education. The subsequent effect is that the
quantity consumed rises to OQs, the socially
optimum level of output where MSB - MSC.
27

Effectiveness of Implementing Taxes and
Subsidies
1. Many economies favor the tax / subsidy solution to the
problem of externalities because it still allows the
market to operate. It forces firms to take on board the
full social costs and benefits of their actions. It also has
the flexibility of being adjustable according to the
magnitude of the problem. For example, the bigger the
external cost of a firm's actions, the bigger the tax can
be.
2. Firms are encouraged to find socially better ways of
producing. The tax, thus, acts as an incentive over the
longer term to reduce pollution. The more a firm can
reduce its pollution, the more taxes it can save. Likewise,
when granting subsidies, firms are given the incentive to
adopt more good practices.
3. Taxes will raise revenue for the government.
28

Drawbacks of Implementing Taxes & Subsidies
1. However, it would be administratively very difficult and
expensive to charge every offending firm its own particular
tax rate or grant every relevant firm its own rate of subsidy.
Given that costs and revenues differ substantially from one
firm to another, separate tax and subsidy rates would be
needed for each firm. Hence, an army of tax inspectors
would be necessary to administer the system.
2. Even if government decides to charge a tax equal to each
firm's MEC or grant subsidy equal to MEB, it would still have
the problem of measuring these costs and benefits. It is very
difficult to estimate the value of the MEC and MEB in
monetary terms.
3. Imposition of polluting tax to cure negative externalities
may also lead to inflationary pressure in the country. Hence,
a government should be very cautious when imposing tax on
its country's industries since it is likely to make its products
more expensive than those of foreign competitors.
29

Other Measures
1. Laws - The firms could be prohibited by law from
producing more than socially optimum, output.
Various polluting activities could be banned or
restricted.
2. Regulatory bodies - Having identified possible
cases where action might be required, the
regulatory body would probably conduct an
investigation and then prepare a report containing
its finding and recommendations.
3. Persuasion - Government runs public campaign to
try to limit the problem.
4. Nationalization - Firms with associated
externalities could be taken into public ownership
and their output controlled to take account of
social costs and benefits. 30

Public Goods / Pure Public
Goods
• A pure public good can be defined as one which is
consumed collectively by all members of a society.
Although it is produced by an individual no one can
be excluded from its consumption even if one does
not pay for the good. No price can be charged or no
profit can be made from these products.
• Production of public goods generates benefits which
go to all the members of a society whether intended
or not. These goods are supplied by the government
using tax revenue. No marginal cost occurs to
provide them to an extra consumer. Example, light
houses, clock towers, street lights, public well,
national security, weather forecast, coastal
conservation, environmental conservation.
31

Two Characteristics of Public Goods
• Non Rivalry –
consumption of the good
by one person does not
reduce the amount
available for consumption
by another person. The
marginal cost of a PG to
additional consumption is
zero.
• Non Excludability – once
provided, no person can
be excluded from its
benefits or effects ( or
indeed suffering in the
case of public good like
pollution). These are only
provided by the
government. Example,
defense, judiciary, prison,
police, street light,
education, health.
32

Semi Public Goods / Quasi Public Goods
• The goods and services that are collective in
consumption, excludable and non rival are called
as semi public goods. Though there is price for
such goods, consumption by one person does
not prevent consumption by others.
• They seem similar to pure public goods. But the
ability to charge a price and ability to exclude
those who are not willing to pay this price,
differentiates pure public goods from semi
public goods. Example, Electricity, Water and
Transport Services.
33

Merit Goods
• Goods or services provided free for
the benefit of the entire society by a
government, because thy would be
underprovided if left to the market
forces or privet enterprise.
• Example, Education, Health Care.
34

Demerit Goods
• A good which is considered unhealthy or
damaging in some way. A demerit good can be
physically harmful (cigarettes), mentally
harmful (gambling), or morally harmful
(prostitution). In many cases, demerit goods
are subject to additional taxes in an effort to
reduce consumption.
• Example, excise taxes, legal control by laws and
fines.
35

ROLE OF THE GOVERNMENT IN THE MARKET
ECONOMY.
• All economic concepts such as tax system, sources
of government revenue, government expenditure,
nature of the budget, its practical results, methods
of financing the budget deficit, sources of internal
and external debts of the government in a particular
year are referred to as public sector economy.
• The relative importance of the public sector in the
economy is different from country to country.
Government contribution is relatively high in
planned economies whereas the same is low in
market economies. In Sri Lanka the government
contribution was relatively high up to 1990s and
then it had gradually declined afterwards.
36

Government Role in a Market
Economy can be as follows
• Allocation/distribution of resources efficiently.
• Distribution of income and wealth
fairly/equally.
• Formulation of rules and regulations and good
governance.
• Stabilization of macro - economic policies.
• Achieving economic development and
sustainable development.
• Provision of infrastructural facilities. 37

The Government has taken the following action
to minimize inefficiency in the
market economy.
• Production of public & welfare goods.
• Prevention of imperfect competition.
• Greater focus on the prevention of
externalities like environmental
pollution.
• Ensuring the ownership of public
resources. 38

The Government Takes Following Actions
To Ensure Equity.
• Redistribution of income and
wealth.
• Limitations on assimilation of
wealth.
• Land reforms.
39

• The government makes use of fiscal policy to
minimize inflation and unemployment in order to
achieve macroeconomic stability. The government
endeavors to increase the level of economic
development and the level of development of the
country.
• The government provides the following in order to
develop infrastructure facilities.
• Provision of physical Infrastructure facilities.
Example; Main roads, highways, bridges, airports,
buildings.
• provision of institutional infrastructure facilities.
Example; Legal structure, courts, regulatory
institutions.
40

Government Intervention
• All governments in the world intervene the
market to a greater or lesser extent and the
reasons for the intervention vary
enormously between them. However, the
justification for intervention is usually given
under 2 broad headings;
“Market failure and the desire to
achieve a fair or equitable distribution
of resources in economy.”
41

• The 1st intervention occurs when markets do
not allocate resources efficiently and the 2nd
is concerned with ensuring that all members
of the society have fair access to goods and
services.
• The role of the government is to intervene in
markets that are not seen to be allocating
resources in the most efficient or equitable
manner. When government attempt to
achieve this aim it must be recognize that
there is also the possibility that they will fail
and create rather than remove distortions. 42

Methods of Government Intervention
• Government policy and the methods of
intervention can be summarized under 4
broad headings; Regulations, Financial
Interventions, Production and Transfer
Payments.
• The method chosen will depend to a large
extent on whether the reason for
intervention is concerned with market
failure or with the desire to achieve equity.
43

Regulations
• The government uses a large number of methods of
regulation as a means of controlling a market. Legal
and other methods are used to control the quality
and quantity of goods and services that are
produced and consumed. For example, the
government may regulate the sale of certain drugs
by making them only available on prescription from
a qualified doctor.
• Hygiene law's set standards for the production of
foods. there ay be controls on shop opening hours
or the setting of a minimum age at which a person
can buy certain products such as alcohol, cigarettes.
44

• Other forms of regulation may include the
requirement for an individual to purchase an
insurance policy before being legally permitted
to drive a car, the age at which people are
required to attend school and the payment of
social incurrence contributions.
• Regulation may not apply to the quantity and
quality of gods and services sold but may also
refer to prices. Examples of price controls
include minimum wage legislation, maximum
price and rent controls.
45

Financial Intervention
• Financial tools, such as taxes and subsidies, are
also frequently used by governments to
influence production, prices of commodities,
incomes or the distribution of wealth in an
economy.
• Price subsidy may vary. They might be in the
form of a partial subsidy, as in the case of public
transport, or total, as in the case of free health
care and free education.
46

• Tax instruments may also vary. For example, excise
tax, which contributes 15% of the total tax
revenue during 2010, is levied mainly on liquor,
tobacco, petroleum, and motor vehicles.
• Governments also provide the finance that is
needed to produce a good or service. It is very
important to note at this early stage that just
because the government provides finance for a
product, it does not necessarily mean it has to
produce the product too. For example, the
government could finance education but some
schools, universities are privately owned and run.
Health care may be provided free but the drugs
used in prevention and cure of illness could be
privately produced.
47

State Production
• In addition to providing the finance it is also possible for
a government to take over the production of a good or
service, either in whole or in part. State owned
industries are often referred to as nationalized
industries. Industries such as the electricity, coal, mining
and railway industries are entirely owned by the state in
many countries.
• It is very important and common to find some goods
and services being produced by both the state and
privet sectors. Education and health care are particularly
good examples of these types of service industries.
National hospitals and government schools function
alongside and privet hospitals and schools also function
separately. 48

Income and other Transfers
• Income transfers are used by the governments as a means
of redistributing income or transferring income from one
group to another group, for example, from people in work
to those who are retired or from relatively rich people to
those who in poverty.
• The justification for these transfers is to achieve fairness
or equity in an economy. These transfers of income may
be in the form of cash benefit paid by the government to
someone with a low income. This may be used to cover
the unexpected loss of income when a person is not
working due to illness or unemployment. These cash
transfers include social security benefits, such as income
support, a job seekers allowance or a state pension. in Sri
Lanka such as, PinPadi, state pension, EPF & ETF.
49

The Impact of Government Intervention in
the Market.
• A rational assessment of government
intervention requires an assessment of costs as
well as the potential benefits. They are;
• Internal Costs refers to the governments costs of
administering its policies. Example, government
inspections on health standards, industrial safety
and environmental protection.
• Direct External Costs refer to the costs imposed
on the non government sector by these policies
in such terms as extra production costs, costs of
compliance and losses in productivity.
50

• Indirect External Costs refers to the efficiency
losses resulting from the alternations in price
signals caused by government tax and
expenditure policies. Example, regulating new
drugs to enter market which are not safe,
control of price of goods and services.
51

Government Failure
• Government Failure – not achieving some
possible gains – can arise because of rigidities
causing a lack of adequate response of rules
and regulations to changing conditions, poorer
insight on the part of the government
regulators compared with private participants
in the market, and government objectives –
such as winning the next election – that conflict
with such objectives as improving economic
efficiency.
52

The Causes for Government Failure
• Imperfect knowledge or foresight – regulators may not
know enough to set correct standards. Example, natural gas
prices.
• Rigidities – regulatory rules and allocations are hard to
change. Example, technological changes.
• Inefficient means – government may fail to choose the least
costly means of solving a problem.
• Myopic regulations – regulation may become too restricted
and too narrowly defined because the regulators are forced
to specialize. Example, railroad industry.
• Political constraints – political reality may prevent the right
policy from being adopted, even when it has been clearly
identified.
• Decision makers objectives – governments own goals and
objectives with respect to their political thoughts.
53

The Fiscal Policy to Achieve
Macroeconomic Objectives
• Fiscal policy is the management of
the government budget to attain
price stability, near full employment,
and a satisfactory rate of economic
growth.
• To attain these goals, the government
must manage its spending and taxes.
54

• Fiscal policy is usually relating to
taxation, government spending and
public debt, with the instruments of
full employment, price stability, and
economic growth.
• The instruments of fiscal policy are;
Public expenditure
Taxes
Public debts
55

Fiscal Policy
EXPANSIONARY
FISCAL POLICY –
increase in government
expenditure & or a
decrease in taxes that
causes the government
budget deficit to increase
or its budget surplus to
decrease.
CONTRACTIONARY
FISCAL POLICY –
decrease in government
expenditure & or an
increase in taxes that
causes the budget deficit
to decrease or its budget
surplus to increase.
56

The use of Fiscal Policy to Achieve
Macroeconomic Goals.
 Full Employment.
 Price Stability.
 Economic Growth.
 Balance of Payments stability.
 Equity in Income and Wealth
Distribution.
 Sustainable Development.
57

Full Employment
• Achieving the objective of full employment means holding
national product at its potential, or full employment level. It does
not mean achieving zero unemployment. Indeed, zero
unemployment is an impossibility in any real economy because of
the normal turnover of labour.
• Turnover occurs because people leave one job to take, or look for,
another, and because there are always some people leaving the
labor force due to retirement, or death, and others entering it.
• As a result, there is always a pool of people who are unemployed
because they are currently between jobs or looking for their 1st
job. Such unemployment, which is due to the normal turnover of
labour, is called frictional unemployment. It is the amount of
unemployment that exists when output is at its potential level.
58

• Accordingly, a more realistic interpretation of full
employment suggests itself; full employment is
achieved when the number of registered
unemployed people is equal to number of job
vacancies.
• The labour market consists of 2 groups, namely
households who supply labour and firms who
demand labour.
• When the supply of labour is equal to the demand
for labour, the economy is in fully employment.
When labour supply exceeds the demand, there is
surplus labour. This results in unemployment in the
economy. This is a major economic problem in Sri
Lanka since independence.
59

LABOUR
FORCE
ECONOMICALLY
ACTIVE POPULATION
– persons who are
employed and who
are willing to work,
but unemployed.
ECONOMICALLY
INACTIVE
POPULATION – who
are unable to engage
in productive
employment, they
include children,
elderly and disabled.
60

61

• In Sri Lanka the overall employment levels
remained stagnant until the late 1970s. Slow
economic growth during that period did not permit
to absorb the growing labour force in that period.
• With the economic liberalization of the economy in
1977, the GDP growth accelerated and more jobs
were created in the newly growing sectors like
manufacturing , banking and financial services,
construction and trade. As a result , the total
employment rose from 3.8 million in 1973 to 4.7
million by 1981/82. it reached 6.4 million by 2002.
• Today, Sri Lanka’s total labour force reached to
8.864 million by 2013 compared to 8.254 million in
2012.
62

63

Price Stability
• Economic and price stability is a situation where
there are no wide fluctuations in the general price
level in an economy which helps to achieve
sustainable economic growth. When the prices
fluctuate at a low rate, they would not have any
significant influence on economic decisions of
participants of an economy, viz. households and
firms.
• Therefore, stable prices would not distort the
economic decisions regarding what to produce and
how to produce, thus enabling efficient allocation of
resources in the economy leading to economic
stability.
64

• Price Stability is the economic term used to refer to a
situation where the general price level covering
Consumer goods remains unchanged or if it does
change, it happens at a low rate so that it is not strong
enough to make any significant influence on economic
decisions of participants in an economy, viz. households
and firms.
• We encounter prices in different forms in our daily
activities as buyers or sellers when we get engaged in
consumption, investment, production or trade.
• In a market economy, price changes are a common
phenomenon depending on the demand for and supply
of goods and services. Since prices change in both
directions and in different magnitudes, it is difficult to
figure out the general movement in prices by examining
each individual price change in isolation 65

• The price level is usually examined through a
“basket of goods” approach, in which a
collection of consumer based goods and
services are examined in aggregate; changes in
the aggregate price over time will push the
index measuring the basket of goods higher.
• Price levels provide a snapshot of prices at a
given time, making it possible to review changes
in broad price level over time.
• As price rises (inflation), or fall (deflation),
consumer demand for goods is also affected,
which leads broad production measures like
gross domestic product higher or lower.
66

Economic Growth
• Economic growth is a major concern of
Macroeconomics. Economic growth means
a rise in real income or real output.
• Very often, economists use the rate of
change of national income to measure
economic growth.
• Most of the countries measure the GDP
growth in real terms. Economic growth in a
particular year is measured as the rate of
change in real GDP over the previous year.67

• Sources of economic growth ; the total output or
GDP of an economy depends on the quantity and
quality of various resources that are used as inputs in
production. These include land , labour, capital and
raw materials. Producers can raise their output by
the following 2 methods:
By increasing factors of production: land, labor,
capital and raw material.
By increasing the productivity of factors of
production: this means an increase in output with
the same quantities of inputs. This can be achieved
by several ways:
A. By improving human capital through skills
development.
B. By technological progress.
C. By adopting new management techniques. 68

Balance of Payments Stability
• Maintenance of equilibrium in the external
payments positions, known as the balance of
payments equilibrium and also is one of the
macroeconomic goals.
• Continuous external deficits reduce the
country's capacity to import and leads to an
accumulation of foreign debt. Hence it is
important to reduce the external deficits. The
main policy instruments that are used to attain
macroeconomic stability is the fiscal policy.
69

• The use of government spending, taxation and
borrowings for the achievement of
macroeconomic stability. The monetary policy
also known as the management of the money
supply, cost of money and credit conditions by
the central bank so as to achieve
macroeconomic goals.
• These two sets of policies are closely
interrelated, and they may be contradictory at
times. For example, when the government runs
a high budget deficit, monetary authorities
would find it difficult to mange the money
growth.
70

Income & Wealth Distribution
• Justice or fairness in the manner in which the economy’s
output is distributed between individuals. distributional equity
is some times expressed in terms of the distribution of income,
of wealth.
• This is also a policy concerned with altering the pattern of the
personal distribution of income in an economy, mainly with
social rather than economic objectives in mind.
• The general aim of such a policy is to achieve a more equitable
distribution of income as between the various sections of the
community so as to ensure that everybody is provided with
some minimum standard if living. The transfer of income from
one section to another is achieved primarily by the use of a
progressive taxation system and a verity of welfare provisions.
Example. Housing schemes, old age pensions, etc. 71

Sustainable Development
• Sustainable development is the development
which meets the needs of the present
generation without compromising the needs of
future generations.
• The term 'sustainable development' was used by
the Brundtland Commission, which coined what
has become the most often-quoted definition of
sustainable development: "development that
meets the needs of the present without
compromising the ability of future generations
to meet their own needs.
72

• In 1987, the United Nations released the
Brundtland Report, which included what is
now one of the most widely recognized
definition said above.
• The concept of sustainable development
divided in to three constituent parts:
environmental sustainability, economic
sustainability and socio-political sustainability.
• In real terms all the macroeconomic variables
should be directed towards economic
development so as to mange the domestic
economy successfully.
73

• According to the Brundtland report, the above
definition contains main two key concepts:
• the concept of 'needs', in particular the
essential needs of the world's poor, to which
overriding priority should be given;
and
• the idea of limitations imposed by the state of
technology and social organization on the
environment's ability to meet present and
future needs.
74

Issues in Achieving
Macroeconomic Goals.
• A central issue in macroeconomics is whether or
not markets, left alone, automatically bring about
long run economic equilibrium. If the free
operation of market forces eventually resulted in a
full employment level of national income with
stable prices and economic growth, there would be
no need for government intervention in the macro
economy - no need for fiscal, monetary ,exchange
rate and supply side policies.
• The reality is that all governments intervene
through their macroeconomic policies in a bid to
achieve certain policy objectives and improve the
overall performance of the economy.
75

Demand Management
• Demand management occurs when the
government attempts to influence the level and
growth of AD hence the levels of national income,
employment, rate of inflation, growth and the
balance of payments position.
• Reflationary policies seek to increase AD and
raise the level of planned expenditure at or near
the level of potential GDP.
• Deflationary policies decrease AD in the event of
aggregate demand running ahead of AS and
posing inflationary risks or leading to an
unsustainable deficit on the balance of payments.
76

The Main Problems of Managing the
Macroeconomy
• The government’s task of managing the
economy is made difficult by several factors
some of which are discussed below:
• Inaccurate Economic Data: All of the main
macroeconomic indicators are subject to a
margin of error. They rely on statistical data
collected from tax returns and surveys and
data is often revised many months after its
first release.
77

• Conflicting Policy Objectives: A policy of stimulating
aggregate demand may reduce unemployment in the short
term but initiate a period of higher inflation and make worse
the current account of the balance of payments. Choices
have to be made between objectives i.e. there exist trade-
offs between them.
• Selecting the Right Policy Instrument: Each macroeconomic
objective requires a separate policy instrument: The usual
‘rule of thumb’ is that one main policy instrument should be
assigned to one policy objective.
• So, for example, interest rates might be assigned as the main
instrument for keeping control of inflation, whilst fiscal policy
instruments such as changes to the tax system might be
allocated to achieving some supply-side objectives such as
increasing the labour supply, boosting incentives, raising
investment and increasing productivity. There are quite deep-
rooted disagreements between some economists (who
belong to different ‘schools of thought’) as to which policies
are most effective to meet a certain objective.
78

• Uncertain time lags when running a policy: Changes in
economic policies are subject to uncertain time lags e.g.
a change in interest rates is estimated to take some 18-
24 months to work its way fully through the whole
economy to filter through to a change in prices. The
length of the time lags can change over the years as the
reactions of consumers and businesses to policy
measures alters.
• External shocks: Unexpected external shocks to
economy such as the events surrounding Sept 11th 2001
or unexpected volatility in exchange rates and
commodity prices can upset economic forecasts and
take the economy some distance from the expected
path. The Government might under-estimate or
exaggerate the potential impact of an economic shock
to either the demand or supply-side of the economy
and therefore apply too little or too much of a policy
response.
79

The Tax System as a Main
Source of Government
Revenue.
• What is tax? Tax is a legal obligation which impose a
financial charge or other levy upon an individual or
legal entity by a state or the functional equivalent of
a state.
• Tax is not a voluntary payment or donation, but an
enforced contribution, exacted pursuant to
legislative authority. In modern time taxation
systems, taxes are levied in money. raising the tax
rates were being a severe issue in Sri Lanka.
• There are 2 major revenue sources of the
government which are; tax revenue and non tax
revenue.
80

The Principle of Taxation
• Since the general public believes
government has the authority to impose
tax on them and the government should
also have a responsibility not to over
burden the general public using the tax.
Thus the government should obey the
following principles of taxation when a tax
is imposed.
81

Principle of Equity
• This tax principle enforces the just or the
fairness of the tax system. In this it prescribes
to tax on general public considering “ ability to
pay or ability to bear the burden of the tax.”
under this concept there are 2 main
suggestions are presented.
• Horizontal equity – this is achieved when
people in the same financial circumstances pay
the same amount of tax.
• E. g. 2 persons who get the same income
should be taxed similarly.
82

• Vertical Equity – people in the different income levels
should be taxed differently. E. g. – higher tax from higher
income earners and low tax from less income earners.
• Principle of economy – the cost of tax collection and
administration should be small in relation to the total
revenue for both the government and tax payer.
• Principle of convenience – taxes should be convenient for
tax payers to pay and for the government to collect.
Otherwise tax payers will be demotivated to pay the tax.
• Principle of certainty – this suggests the tax system the
way in which the tax is imposed should not be changed
frequently. If the ax system changes frequently investors
and other parties cannot predict the tax payments that
they should pay in the future. This will demotivated the
tax payer.
• Principle of efficiency – tax should not be reduce the
economic efficiency and ideally increase it. E. g. taxes on
environmental pollution, taxes on demerit goods. 83

• Principle of flexibility – a tax should be capable
of being changed to meet changing economic
conditions and changing government
objectives.
• Principle of neutrality – neutrality refers to the
absence of distortions of the market
mechanism and adverse effect in the economy.
That is a tax should not adversely effect on
economic agents. When a tax is imposed it
should cause minimum affects on consumption,
production, investments, savings.
84

Taxes
Direct tax – is the
tax where the
burden of the tax
is owned by the
tax payer himself
and there is no
possibility to
transform the
burden to
another. E. g.-
income tax
Indirect tax – these are
taxes on expenditure,
which can be
transferred to other.
When the government
imposes an indirect tax
on producers, they can
transfer the tax burden
to consumers by raising
the prices of the
products.
85

Progressive Tax
• This is a tax method where there is a positive
relationship between the income and the tax
rate. If the income of individuals goes up the
tax rate also responds in a positive way.
• Income Tax
• 10,000 10%
• 20,000 20%
86

Proportionate Tax
• If the tax rate or the ratio does not vary with
tax base (income), such tax method is called
proportionate tax.
• Income Tax
• 10,000 10%
• 20,000 10%
87

Regressive Tax
• This is the tax method where there is negative
relationship between tax base and tax rate.
That is the tax rates decreases when tax base
(income) increases.
• Income Tax
• 10,000 10%
• 20,000 8%
88

• According to the budget for 2013, total
government revenue in 2013 is estimated
to increase by 19.6 % to Rs. 1247.5 billion.
• Total government revenue as a percentage
of estimated GDP, declined to 5.5% during
the 1st half of 2013 from 6.9% in the same
period of 2012.
• The share of the tax revenue in the total
revenue increased to 90.4% in the 1st half
of 2013 from 88.0 % in the corresponding
period of the previous year.
• Non tax revenue declined to 9.6% in the 1st
half of 2013 from 12.0% in the
corresponding same period in 2012.
89

Recent Changes in the
Government Expenditure.
• The government expenditure is classified in to
following 2 categories.
• Current expenditure – this is the spending on
the day to day running of the public services.
E.g. government servants salaries, the purchase
of medicines, the pay of those in armed services
and the purchase of uniforms, interest
payments on public debts etc.
• According to the functional classification divided
in to 3 main categories.
90

91

92

The Economic Classification of
Government Expenditure
Current
Goods &
Services
Social
Services
Economic
Services
Others
Capital
Goods &
Services
Social
Services
Economic
Services
Others
93

Current
Expenditure.
Current
Expenditure
on Goods &
Services.
Interest
Payments.
Current
Transfers
& Subsidy.
94

Current Expenditure on Goods
& Services.
• Current expenditure on goods and services is
recurring spending or, in other words, spending on
items which are consumed and only last a limited
period of time. They are items which used in the
process of providing a good or service. In the case o
government, current expenditure would include
wages and salaries and expenditure on
consumables – stationary, drugs for health services,
and so on. This can be divided in to 2 groups.
• Salaries and wages
• Other goods and services.
95

Interest Payments
This contains 2 main divisions,
1.Interest payments on foreign
debts
2.Interest payments on local
debts.
96

Transfer Payments and
Subsidies.
• A transfer payment is a payment which no good or
service is exchanged. In other words money has
simply been transferred from one person to
another without anything being done for it.
• This has main 2 components.
• Transfer payments to government services and
institutions. E.g. railway department.
• Transfer payments to households and other sectors.
E.g. Samurdhi scheme, pensions, fertilizer subsidy,
school text books, uniforms, donations for
displaced people.
97

98

99

Capital Expenditure
• This is spending on the social infrastructure and
includes, e.g. spending on new hospitals, schools
and roads. Capital expenditure adds to the
country's capital assets.
• According to the economic classification, capital
expenditure has the following sub divisions.
• Achieving of real assets – (capital assets),
rehabilitation and maintenance cost.
• Capital transfers.
100

• Purchase of properties and buildings are included
in capital expenditure on acquisition of real assets.
The capital transfers to government co-operations,
government office and boards are all included in
capital transfers.
• Government makes investments directly mainly
due to the following reasons.
1) There is a need for the production of some capital
goods which are not produced by the private
sector in order to ensure economic growth.
2) Provide facilities and services which are needed to
create a conducive environment for investments
by the private sector.
101

Government capital expenditure
and net lending were limited till
recent times due to:
1) increase in expenditure in defense.
2) increase in loan payment (payment of
interest on loans)
3) increase in current transfers.
102

The following factors have affected
gradual increase in government capital
expenditure in recent years.
• Examples of large scale Infrastructural
development projects.
1) Gama Neguma
2) Southern Province rural development projects.
3) Small scale irrigation projects.
4) Rehabilitation and provincial government
projects
103

104

105

Functional Classification of
Government Expenditure.
• Under the functional classification of
government expenditure, Both current and
capital expenditure are divided in to 4
subsections. They are;
• General and public expenditure
• Social service expenditure
• Economic service expenditure
• Other expenditure
106

The Economic Effects of
Government Budget Policies
• The budget is an account of planed expenditures and
expected receipts of the government for the forthcoming
year. It is contained in the budget speech presented
annually by the minister of finance to the parliament of
Sri Lanka. The budget is not only a presentation of
government finance, but also a statement of government
economic policies.
• The fiscal policy of the government is implemented
mainly through the budget proposals. The budget id
formulated by the general treasury which I under the
preview of the minister of finance. The general treasury
deals very closely with the line ministers in preparing the
budget. 107

Types of Budgets
Budget
Balanced Surplus Deficit
108

Balanced Budget
• A government budget is said to be a balanced
budget in which government receipts (revenue
and capital) are shown equal to the
government expenditure.
Balanced Budget =
Estimated Gov. Receipts =
Estimated Gov.
Expenditure.
109

Surplus Budget
• When government budget receipts
are more than government
expenditure in the budget, the
budget is called as a surplus
budget. In other words a surplus
budget implies a situation wherein
government revenue is in excess of
government expenditure. 110

• A surplus budget shows that government is
taking away more money than what it is
pumping in the economic system as a result,
aggregate demand tends to fall which helps in
reducing price level. Therefore in times of
severe inflation a surplus budget is the correct
one. But in the case of deflation and recession
surplus budget should be avoided.
Surplus Budget = Estimated
Gov. Receipts > estimated
Gov. Expenditure.
111

Deficit Budget
• When government expenditure exceeds than
the government receipts in the budget, the
budget is said to be a deficit budget.
Deficit Budget =
Estimated Gov.
Expenditure > Estimated
Gov. Revenue.
112

Revenue Deficit
• The excess of revenue expenditure over revenue
receipts called as revenue deficit. It implies that
resources have to be borrowed from other
sectors of economy to cover this deficit. It ay
lead either to borrowing or sale of government
asset thus high revenue deficit give a warning
signal to the government either or curtail its
expenditure or increase its revenue.
Revenue Deficit = Revenue
Expenditure – Revenue Receipts.
113

Fiscal Deficit
• Fiscal deficit is the excess of total expenditure
over revenue receipts (revenue and capital
receipt) excluding borrowing. Fiscal deficit
therefore, is a compressive measure of the
implications for economy. The government has
to borrow to meet this deficit, a major part of
fiscal deficit is financed by the deficit financing
(printing extra currency notes). It leads to rise in
the prices.
Fiscal Deficit = Total Expenditure –
Revenue Receipts – Capital Receipts
(excluding borrowing). 114

Primary Deficit
• The excess of fiscal deficit over payments of
interest is called primary deficit. This shows how
much of the government borrowing is going to
meet expenses other than interest payment. A
lower primary deficit indicates that the interest
payment has forced the government to borrow.
Thus it indicates the real position of government.
This can be calculated as Follows;
Primary Deficit = Revenue Deficit –
Interest Payments or
Primary Deficit = Total Revenue – Total
Expenditure except interests
115

How to Correct The Budget Deficit?
• Expansionary and contractible budget policies are used to
settle the budget deficit. If the loans that are obtained to
settle budget deficit increases the money supply in the
country, such loans are known as “expansionary loans”. If
the loans taken do not affect the supply of money in the
economy, they are known as “contractible loans”
• Examples of expansionary loans are as follows.
Government obtaining loans from the Central Bank.
Obtaining loans from the Commercial Banks.
 Obtaining foreign loans.
• Examples of contractible loans are giving below.
Obtaining loans from non-banking institutions.
Taking loans from the general public.
• Contractible budget policies are more favorable for an
economy than expansionary budget policies.
116

The Deficit Budget in Sri Lanka.
• An excess of government expenditure over
its revenue results in a budget deficit.
Budget deficits lead to many economic
problems including high money growth,
high inflation, government borrowings and
high interest rates. When spending its
greater than revenue, the excess spending
must be covered by borrowing, and this
borrowing can effect on investment and
consumptions well as economic
relationships with other countries.
117

• In 2012, the overall budget deficit of Rs. 489
billion was largely financed through foreign
sources. Accordingly, foreign financing
contributed to around 59 per cent of the total
compared to Rs. 207.6 billion expected in the
budget.
• However, the share of non bank sector
borrowings in total domestic borrowings
increased to 35 per cent in 2012, compared
to 19 per cent in 2011. As in previous years,
the Employees’ Provident Fund (EPF) and the
National Savings Bank (NSB) continued to be
the key institutional investors in the non
bank sector.
118

• In line with the medium term debt
management strategy of improving the
government securities market while
reducing the risks associated with
government debt portfolio, the
government relied heavily on marketable
debt instruments with longer maturities
to finance the budget deficit in 2012.
Accordingly, net borrowings by way of
instruments financed through non
commercial sources. The Asian
Development Bank (ADB), China and
Japan were the major sources of non
commercial loans.
119

The Reasons for the Budget
Deficit in Sri Lanka.
• We can identify the following weaknesses of
the Sri Lankan government budget.
The government spend more than it
earns. This leads to a budget deficit.
The government has to borrow to
finance the deficit.
The government disserves, thereby
absorbing the part of private sector
savings.
120

• Examples of factors that affected
budget deficit in Sri Lanka in recent
years.
Reduction in tax revenue due to tax
relief.
Increase in expenditure when paying
Bank debts.
Increase in transfer costs of the
government.
Increase in expenditure on public
sections.
121

Various steps have been taken to
settle the budget deficit in Sri Lanka.
• E.g. Use of foreign financial resources
Foreign loans.
Foreign grants.
Use of local financial
resources.
Borrowing from the
market.
122

.
• The constant budget deficit will have
many effects on the economy of a
country.
• Examples
Increase in state loans.
Increase in inflation.
Decrease in investment by private
sectors.
Rise in interest rates.
Declining international credibility.
Reduction in foreign exchange rates/
values.
Decrease in local savings.
123

• An economy can gain many things as it reduces
budget deficit. A deficit in the current account of
an economy will results in disadvantages, effects
and a surplus in a country’s current account will
results in advantages.
• The advantages of having a surplus in current
account are as follows.
Reduction in burden of state loans.
Decrease in inflationary effects.
Increase in government investments.
Ability to maintain interest rates at a
low level.
Reduction of tax burden on people.
Leading to macroeconomic stability. 124

Budget Deficit & Its Financial
Implications.
• As we observed above, the
government spending has exceeded
its revenue, resulting in continuous
budget deficits. These deficits are a
major macroeconomic problem in Sri
Lanka.
• The government has to borrow from
the following 2 sources to finance
the deficit.
125

Foreign Sources
• These include concessional and non
concessional loans. Continuous
borrowings from abroad have led to the
accumulation of a large foreign debt.
Annually, the country has to allocate a
large amount of foreign exchange to meet
the capital repayments and interest
payments on these loans.
126

Domestic Sources
• The government can borrow from the banking
sector or non banking sector for deficit financing
purposes. As resources available in the non
banking sector were rather limited, the
government relied heavily on the baking sector.
• This led to a rapid increase in the money supply
causing macroeconomic instability. Since 2002,
however, the government not only managed to
avoid borrowing from the banking sector, but
government has actually succeeded in repaying a
part of past bank borrowings. This reduced the
high inflationary deficit financing. Also it eased
pressure on interest rates.
127

Criticism
• A major criticism raised against deficit financing
policies is that excessive government spending
leads to reduce private investment which is much
more productive.
• This is known as the crowding out hypothesis:
large budget deficits are financed by treasury
borrowing, while then crowds private borrowers
out of financial markets and drives up interest
rates.
• The crowding out effect arises because government
expenditure increases the interest rate. The rise in
the interest rate causes a fall in the private
investment speeding. This kind of all investment is
called as crowding-out effect.
128

Fiscal Management
(Responsibility) Act.
• The fiscal management act, which came into effect
in 2003, is an important landmark in the country's
fiscal management. It reflects the governments
commitment to improve transparency and
accountability in fiscal management.
• The act requires reducing the budget deficit to 5%
of GDP by 2006, and maintained it below that level
thereafter. It also requires reducing the
government debt as a ratio of GDP to 85% by 2006
and to 60% by 2013. it is the responsibility of the
government to maintain these fiscal targets. 129

130

131

132

The Composition of State Loans
• The loans that the government takes on
the condition that its pays it back with
interest is known as state borrowings. The
government borrows from local sources as
well as foreign sources.
• The borrowings of the state from the
monetary market and capital market are
known as “market borrowing” (loans).
133

Examples.
 A large part of government revenue has to be paid as loans
and interest on the loan.
 Only a small part of the government revenue remains behind
in order to spend to achieve development objectives and for
other needs.
 Increase in interest rates in the local market.
 Decrease in external value of the local currency.
• Reduction in resource allocation to the public sector reduce private
investments and it has a negative effect on economic development.
Difficulty in state monetary system management and state debt
management causes inflation. Creation of inflation due to borrowings
from banking sector. Balance of payment problems arise as a result of
increase in total expenditure. This leads to face a crisis in international
debt.
 Decline in local savings rate.
 Damaging international competition by the decrease in monetary
value of foreign exchange rates due to inflation in the economy.
134

• Payment of loan installments with interest on the
total state borrowings is known as debt service
payment".
• The loan installments on the total borrowings of
the government and the interest to be paid on
them can be shown as a percentage of domestic
production. It is known as debt service ratio.
• Different types of debt service ratios can be
calculated by using debt installments and
interests, export revenue, government revenue
and government expenditure. The debt service
ratios are calculated in different ways an shown
as debt service index.
135

• Examples of recent trends of borrowings of Sri
Lanka are;
Continuous decrease in the debts that have not been
settled as a percentage of the gross domestic
product.
A large amount of the total borrowings is domestic
(local) loans.
Middle term and long term loans are greater than
the short term loans according maturity period.
Loans taken from non-banks are greater than the
loan taken from banking sector.
The main component (instrument) of unsettled local
loans is treasury bonds.
The loans on concessional interest rates are more
important in foreign loans.
136

The Composition of State Loans
& Trends, Public Debt Crisis.
• Sri Lanka has maintained an annual average investment of about
27 per cent of GDP over the last decade compared with its
annual average national savings ratio of about 22 per cent of
GDP. Such investments, partly funded through foreign
borrowings, directly helped the country to achieve a higher
economic growth thereby tripling the per capita income to USD
2,923 in 2012 from USD 981 in 2003.
• If however, the Government had restricted the public
investments to the country's national savings only, the people of
the country would not have been able to secure the higher
growth momentum as achieved. In a similar manner, in the near
future too, Sri Lanka would need to attract foreign resources,
including borrowings, to bridge the investments savings gap,
until such time that the domestic savings are sufficient to
finance the required level of national investments.
137

• During the recent past, the global debt market
continued to provide greater diversification, wealth
preservation and attractive returns. As a result, the
demand for debt instruments, particularly in
emerging markets has increased sharply.
Approximately 75 per cent of the global financial
instruments today constitutes debt, whereas the
relative share of equity is only about 25 per cent.
Since strong investor sentiment has reduced the
effective cost of debt to substantially low levels, Sri
Lanka has also benefitted from such positive
development, as reflected in Sri Lanka’s
progressively lowered cost of borrowing from
international markets.
138

• The prudential debt management strategies
implemented by the Central Bank over the past
few years has served to ensure that both the
level and rate of growth in the country’s public
debt is sustainable, and the cost and risk
objectives stipulated in the medium term debt
management strategy are met. At the same
time, the continuous commitment of the
Government towards fiscal consolidation has
helped the country’s debt to GDP ratio to
record about 79 per cent, down sharply from
about 106 percent in 2002.
139

• The responsibility of the management of public
debt in Sri Lanka has been entrusted to the
Central Bank of Sri Lanka under the Monetary
Law Act No.58 of 1949.
• This function needs a high level of
professionalism, analytical ability, awareness
and confidence of all stakeholders including
lenders to the government and investors in
government securities.
140

• The public debt stock as at end 2012 stood at Rs. 6.0
trillion consisting of domestic debt of Rs. 3.2 trillion
and foreign debt of Rs. 2.8 trillion. Foreign debt
constitutes loans received from a number of multi-
lateral institutions, bi-lateral loans and other
commercial debt in a number of currencies. The size
and the diversity of the public debt portfolio demand
a high level of analysis and sharing of information
with the stakeholders. To fulfill this need, the Central
Bank of Sri Lanka started in 2006, disseminating
information in the form of an annual publication with
regard to the public debt portfolio and the debt
management function, aiming to enhance the
transparency of the debt management function.
141

• The objective of public debt management is
to ensure that the government's financing
needs are met at the lowest possible cost
consistent with a prudent degree of risk, and
to develop enhancing its efficiency and
maintaining its stability.
• Although the strategic objective to be pursued in public
debt management has not been made explicit by any law
in Sri Lanka, it is implicitly understood that public debt
management should be carried out in such a way as to:
 Minimize the direct and indirect cost of public debt
on a long-term perspective;
 Prevent an excessive concentration on
redemptions and thereby minimize any type of
rollover risk/refinancing risk;
 Promote an efficiently functioning government
securities market.
142

The Structure of State Loans.
State Loans
Local
Borrowings
Market
Banks
Central
Bank
Com.
Banks
Non
Banks
Insurance
Firms
EPF
Savings
Institutions
Non
Market
Foreign
Borrowing
s
Projects Non
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The Effects of the Government
Supply Development Policies.
• Supply side policies are designed to increase the
average rate of growth of the country. They may
also help reduce inflation and unemployment and
improve the current account position.
• Some economists, called supply side economists,
believe that governments should not intervene in
the workings of the free market. The governments
role, they argue, is to remove restrictions to the
operations of individual markets. Keynesian
economists believe that governments need to
intervene on the supply side to correct market
failure. 155

• Aggregate supply in the economy can be increased
if government intervene to ensure that labour
markets operate more efficiently and if there is an
increase in human capital over time.
• There are different approaches to implement the
supply side policies by the state.
• They include:
Tax reforms
Privatization
Deregulation
Reforms of Labour market
Reforms of capital market
156

Tax Reforms
• Taxes on labour, firms will not take on workers if
their total wage cost is too high. Part of the
total cost is the wages of workers. However,
many county's tax firms for employing labour,
often by imposing employer contributions to
state social security funds. In Sri Lanka, for
instance, employers have to pay EPF and ETF
contributions. The higher the tax, fewer
workers will be employed and hence the lower
will be the level of aggregate supply.
157

• Making changes in the tax system in order to
increase production is known as tax reforms.
Imposing taxes can affect the competitiveness of
the market. The Optimum level of production,
consumption, investments and savings will be lost
as a result of taxation. Therefore it is important to
be concerned when imposing taxes in order to
minimize influence of taxes on competitiveness of
the market.
• Example - tax relief, tax exemption, reduction of
taxes
• When these concessions are given, cost of
production will be reduced and production will
increased.
158

• Taxes may affect the economy positively and
negatively. Negative effects of tax reforms are;
Reduction of government revenue due to
decrease in taxes.
Increase in unequal distribution of income.
Tendency to increase the consumption of
unwanted goods.
• Positive effects of tax reforms are;
Increase in production.
Covering the losses of tax concession by the
optimum levels of consumption
investments and savings.
• It is important to make use of tax reforms as
supply development policy in a way to
minimize its negative effects on an economy.
159

Privatization
• Privatizing firms, and in the process
creating competition between newly
created firms, eliminates the distortions
created by the operation of public sector
monopolies. Along this the government
also implement deregulation, which is the
process of removing government controls
from the market.
• This leads to encourage the market to
function more efficiently. Making use of
the private sector to manage the business
activities under the ownership of the
government (business activities managed
by the public sector) is known as
privatization. 160

• Different methods of privatization are
given below.
Sale or transfer full or a part of
ownership of public sector firms to the
private sector.
Providing the authority of management
of public establishments to the private
sector.
Taking over of certain private firms
which belong to the public sector.
161

 Privatization can cause both positive and
negative effects on the economy. Positive
effects are as follows.
 Efficient production due to greater productive
employment of resources in the process of
production.
 End of government monopoly and creation of
competitive markets.
 Relieving the burden on government budget.
 Removing political influence on business
activities.
 Harnessing solutions to problems of lack of
capital.
 Rise in quality of goods and services produced.
 Decrease in cost of production
 Prevention of waste, corruption and fraud.
 Receiving quick response to the customer
wants. 162

Deregulation
• Removal of government regulations and the
regulation created by society which (Social
factors) affect to reduction of the
competitiveness in the market is known as
“deregulation”.
• E.g. relaxing the rigid regulations concerning setting up of
a business. (regarding location of a business, getting
approval for accruing the capital to start it.)
• In other word deregulation states, reducing strict
government supervision that can disturb free trade and
also prevent the increase in costs of transaction of goods
as a result of the influence of social factors (when selling
fish, certain individuals demand at a higher price than the
price fixed by the supplier/ producer. This differs the price
which is not given to the producer). 163

• The government remove the obstacles that affects
competitiveness in the market by deregulation and
strengthening the producers. It reduces the cost of
production, increases productivity and helps increase
production. Total deregulation may have a negative
influence on the economy though it affects positively to
reduce cost of production increase investments and
increase production. E.g.
Providing harmful goods and services for
consumption to the market.
Possible production of low quality goods.
Import of unwanted or harmful goods to the
economy.
Deregulation should be carried out within
some limits in order to minimize their ill
effects on the economy. 164

Labour Market Reforms
• The level of aggregate supply is determined in
part by the quantity of labour supplied to the
market and the productivity of that labour.
Classical economists argue that there is a
number of ways in which the quality and
quantity of labour are restricted because
markets are not allowed to work freely.
• The state is making relevant changes in order
to retain the rigid nature of demand and supply
of labour in the labour market.
165

• Example.
Removing rigid / strict labour laws.
Taking actions not to recruit people who are not
competent in certain professions.
Making the workers aware of training
programmes relevant to different jobs.
• Competitive labour market is created by the
reforms done with regard to demand and
supply. It helps to increase the level of
production in the economy.
166

• Control of trade unions by the government is
also important under the labour market
reforms. Because by this the state control the
power of ability of striking by labors. Because
they raise the wage rates and impose their
higher demand, due to this government take
actions to control the trade unions.
• The high marginal tax rates (the tax rate on
the last 1 Rs. earned or spent), discourage
economic activity. A tax on cigarettes leads to
fewer cigarettes being bought. A tax on work
(income tax) leads to people working less. A tax
on profits (cooperation tax) is a disincentive to
firms to make profits. Lowering certain taxes
therefore raise the economic activity and
increase aggregate supply.
167

• But it is important to know that attention
is not paid to implement the reforms
within certain limits, it may have negative
effects on the economy.
E.g. The private firms are given freedom to
recruit people for their firms it may cause
injustice to these worker. When they are
removed from service during the time
there is no adequate work to be done.
• Labour market reforms should be used as
supply development policy to minimize the
negative effects of such reforms.
168

Capital Market Reforms
• Increasing the capital stock of the country, such
as its factories, offices and roads, will push the
aggregate supply curve to the right. According to
classical economists, the government has a key
role to play this.
• Allocating scarce capital sources – the
government is in a poor position to decide how
to allocate resources. It should leave this to
private sector. Hence, state owned companies
should be privatized wherever possible. They
should offer only limited taxpayers money to
subsidize industry. 169

• Increasing the range of sources of capital
available to firms – firms can be
constrained in their growth if they are
unable to gain access to financial capital
like bank loans or share capital. due to
this the state should encourage private
sector to provide loans, partially to small
businesses.
• Along this they must liberalize trade,
which means removing tariffs and other
barriers to imports. 170

• Taking action to solve the problems of
lack of capital that hinders increase in
production is known as “Capital market
reforms”.
E. g.
Increase in productivity of capital
Encouraging direct foreign investments.
Obtaining foreign loans on favorable
terms.
Taking steps to increase savings
171

• Rise of production with increased investments as a
result of these reforms creates a healthy situation. It
may cause an unhealthy situation too.
E. g.
Sending profits and dividends earned from increased
foreign investments to foreign countries.
Spending a large amount of money on loan
installments and interests on foreign loans.
It might affect social welfare negatively if the
government reduced current expenditure.
When capital market reforms are used as supply
development policy, it should be done in a way to
ensure that negative influences are removed.
172

Summary
• When a transaction between a buyer and a
seller directly affects a third party, the effect is
called an externality.
• Negative externalities cause the socially
optimal quantity in a market to be less than the
equilibrium quantity.
• Positive externalities cause the socially optimal
quantity in a market to be greater than the
equilibrium quantity.
173

• A tax on a good reduces the welfare of buyers
and sellers of the good, and the reduction in
consumer and producer surplus usually exceeds
the revenues raised by the government.
• The fall in total surplus—the sum of consumer
surplus, producer surplus, and tax revenue — is
called the deadweight loss of the tax.
• As a tax grows larger, it distorts incentives more,
and its deadweight loss grows larger.
• Tax revenue first rises with the size of a tax.
• Eventually, however, a larger tax reduces tax
revenue because it reduces the size of the
market.
174

• Taxes have a deadweight loss because they
cause buyers to consume less and sellers to
produce less.
• This change in behavior shrinks the size of the
market below the level that maximizes total
surplus.
175

Review Questions
1. Explain briefly what is market failure and their
reasons.
2. What is merit goods, demerit goods and quasi
public goods? Briefly explain.
3. What do you mean by externalities and
explain the externalities of production and
consumption with examples.
4. What is the role of the government in a
market economy? Briefly explain.
5. What is government failure?
176

6. What is a fiscal policy?
7. What are macroeconomic objectives? Briefly
explain.
8. What are the issues in achieving macroeconomic
objectives?
9. Explain the composition of government revenue.
10. What is known as he principle of taxation ?
11. Briefly explain different types of taxes with
example.
12. What is economic classification of government
expenditure?
13. What is functional classification of expenditure?
14. What is budget and explain briefly the types of
budgets.
177

15. Define the types of budgetary policies.
16. What is budget deficit and the causes for
budget deficit in Sri Lanka?
17. How the government of Sri Lanka financing
the budget deficit?
18. Explain with reference to the central bank
report, what is the current situation of public
debt in Sri Lanka.
19. How the government correct the public
debt?
20. What are the supply side policies of the
government? Briefly explain.
178

References
• Colombage. Prof. S. S. ” Principles of
Macroeconomics” 2006. The Open University Press,
Nugegoda, Sri Lanka.
• Lipsy. Richard G. ,” An Introduction to Positive
Economics” 7th Low Price Edition ,1989, Butler &
Tanner Ltd, London.
• Gordon. Robert J," Macroeconomics” 3rd Edition,1984,
Little Brown & Company Canada Ltd, USA.
• Frank. Robert H, Ben S. Bernake, ”Principles of
Macroeconomics”, 2001. McGraw-Hill Companies Inc,
New York.
179

• Pearce. David. W," The Dictionary of Modern Economics”
2nd Low Price Edition, 1985, Anchor Brendon Ltd. UK.
• Dharmawardena. Prasadini, GCE A/ L Economics – New
Complete Text Books for grade 12 & 13, ESL Publishers.
• Central Bank Reports 2009, 2010, 2011, 2012.
• Recent Economic Development Reports from 2008, 2009,
2010, 2011, and 2012.
• Economics and Social Statistics form 2010, 2011,
2012.The Central Bank of Sri Lanka.
• Teacher Guides & Instructional Manuals, Grade 12 & 13.
revised 2012. The National Institute of Education of Sri
Lanka. Mahargama.
180