What Impact Does Economics Have on Government Policy?

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Economic conditions often inform the policy changes that governments elect to enact. And in the U.S. specifically, government policy has always had a large amount of influence on economic growth and the creation of new business entities.

In the broadest sense, the economic activity of a country reflects what people, businesses, and governments want to buy and what they want to sell. Because the U.S. has a capitalist economy that relies on the principles of a free market, theoretically, it is primarily the decisions of consumers and producers that mold the economy.

Key Takeaways

  • Economic conditions often inform the policy changes that governments elect to enact.
  • In the U.S., government policy has always had a large amount of influence on economic growth and the creation of new business entities.
  • For those in political power, having a track record of economic growth is often an important consideration (especially if they are in a position of seeking re-election).
  • In order to ensure strong economic growth, there are two main ways that the federal government may respond to economic activity: fiscal policy and monetary policy.
  • In the U.S., the Federal Reserve System directs the monetary policy of the country.

Governments Intervene to Engineer Growth or Prevent Negative Conditions

However, the government may decide to regulate some aspects of this economic activity in order to engineer economic growth or prevent negative economic conditions in the future. In general, a government’s active role in responding to and influencing the economic circumstances of a country is for the purpose of preserving and furthering the economic interests of important stakeholders or the general citizenry.

For those in political power, having a track record of economic growth is often an important consideration (especially if they are in a position of seeking re-election). In the U.S., many studies have revealed that the economy is a major factor that affects how people vote (specifically in the U.S. presidential election). Strong economic growth typically translates into more hiring and higher wages for citizens, and higher corporate profits. Higher corporate profits are typically positive for the stock market as well.

In order to ensure strong economic growth, there are two main ways that the federal government may respond to economic activity: fiscal policy and monetary policy.

Monetary Policy and Fiscal Policy

Some of the most common ways that a government may attempt to influence a country’s economic activities are by adjusting the cost of borrowing money (by lowering or raising the interest rate), managing the money supply, and controlling the use of credit. Collectively, these policies are referred to as monetary policy.

The government may also adjust spending, tax rates, or introduce tax incentives. Collectively, these policies are referred to as fiscal policy. Government spending and taxes are controlled by the president and Congress. As a result, these elected members of the government have a great deal of influence on the economy.

Fiscal and monetary policies are intended to either slow down or ramp up the speed of the economy’s rate of growth. This, in turn, can impact the level of prices and the employment rate in the country.

The Federal Reserve System

In the U.S., the Federal Reserve System directs the monetary policy of the country. The Federal Reserve System–also just called “the Fed”–is the central bank of the U.S. Established in 1913 by Congress, the Fed controls the money supply and actively uses policy to respond to and influence economic conditions.

The Fed adjusts the interest rate that banks charge to borrow from one another. (This cost is then passed onto consumers.) The Fed may lower the interest rate as a means of keeping borrowing cheap, ensuring that credit is widely available, and boosting consumer (and business) confidence.

Conversely, the Fed may decide to raise interest rates in a strong economy, or in response to inflation concerns–the increase in prices that occurs when people have more to spend than what’s available to buy.

Achieving Financial Stability in the U.S. Economy

Prior to the creation of the Fed in 1913, the U.S. had experienced several severe economic disruptions as a result of massive bank failures and business bankruptcies. As an institution, the Fed was tasked with ensuring financial stability in the U.S. economy.

After the Great Depression, the greatest threat to the stability of the U.S. economy were recessionary periods: periods of slow economic growth and high unemployment rates. In combination, these two factors created a sustained period of decline in the gross domestic product (GDP). In response to this, the government increased its own spending, cut taxes (in order to encourage consumers to spend more), and increased the money supply (which also encouraged more spending).

Beginning in the 1970s, a different economic reality emerged; overall, there were major price increases, which led to a high level of inflation. In response to these economic factors, the U.S. government started focusing less on combating recession and more on controlling inflation. Thus, the government enacted policies that limited government spending, reduced tax cuts, and limited growth in the money supply.

At this time, the government also shifted away from its reliance on fiscal policy–the manipulation of government revenues to influence the economy. The fiscal policy did not prove effective at addressing high levels of inflation, high levels of unemployment, and vast government deficits. Instead, the government turned to monetary policy–controlling the nation’s money supply through such devices as interest rates–in order to regulate the overall pace of economic activity.

Since the 1970s, the two main goals of the Fed have been to achieve maximum employment in the U.S. and to maintain a stable inflation rate. Currently, the Fed’s mandate for monetary policy is known as a dual mandate. This is because, according to the Fed, if there are economic conditions that allow for every person that wants to work to have a job (or secure one fairly quickly) and in which the price level of goods is fairly stable, then it reasonably follows that interest rates will settle at a moderate level.

While outside events may influence economic activity, governments may also use economic means to enact changes. This may range from direct economic action, to tax policy or legislation, but typically government responses to economic conditions involve using multiple strategies simultaneously.

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