The Economic Role Of Government

An ideal market economy is one in which all goods and services are voluntarily exchanged for money at market prices. Such a system squeezes the maximum benefits out of a society's available resources without government intervention. In the real world, however, no economy actually conforms totally to the idealized world of the smoothly functioning invisible hand. Rather, every market economy suffers from imperfections which lead to such ills as excessive pollution, unemployment, and extremes of wealth and poverty.

For that reason, no government anywhere in the world, no matter how conservative, keeps its hands off the economy. In modern economies governments take on many tasks in response to the flaws in the market mechanism. The military, the police, the national weather service, and highway construction are all typical areas of government activity. Socially useful ventures such as space exploration and scientific research benefit from government funding. Governments may regulate some businesses (such as banking and drugs) while subsidizing others (such as education and health care). Governments also tax their citizens and redistribute some of the proceeds to the elderly and needy.

How do governments perform their functions? Governments operate by requiring people to pay taxes, obey regulations, and consume certain collective goods and services. Because of its coercive powers, the government can perform functions that would not be possible under voluntary exchange. This coercion increases the freedoms and consumption of those who benefit while reducing the incomes and opportunities of those who are taxed or regulated.

But for all the wide range of possible activities, governments have three main economic functions in a market economy. These functions are increasing efficiency, promoting equity, and fostering macro-economic stability and growth.

1. Governments increase efficiency by promoting competition, curbing externalities like pollution, and providing public goods.

2. Governments promote equity by using tax and expenditure programs to redistribute income toward particular groups.

3. Governments foster macroeconomic stability and growth—reducing unemployment and inflation while encouraging economic growth—through fiscal policy and monetary regulation.

We will examine briefly each function.

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