The Government's Role in the Economy

High angle view of a group of people in a town, Great Depression, USA, 1930s
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In the narrowest sense, the government's role in the economy is to help correct market failures, or situations where private markets cannot maximize the value that they could create for society.  This includes providing public goods, internalizing externalities, and enforcing competition.  That said, many societies have accepted a broader role of government in a capitalist economy.

While consumers and producers make most decisions that mold the economy, government activities have a powerful effect on the U.S. economy in at least four areas.

Stabilization and Growth. Perhaps most importantly, the federal government guides the overall pace of economic activity, attempting to maintain steady growth, high levels of employment, and price stability. By adjusting spending and tax rates (fiscal policy) or managing the money supply and controlling the use of credit (monetary policy), it can slow down or speed up the economy's rate of growth -- in the process, affecting the level of prices and employment.

For many years following the Great Depression of the 1930s, recessions -- periods of slow economic growth and high unemployment -- were viewed as the greatest of economic threats. When the danger of recession appeared most serious, government sought to strengthen the economy by spending heavily itself or cutting taxes so that consumers would spend more, and by fostering rapid growth in the money supply, which also encouraged more spending.

In the 1970s, major price increases, particularly for energy, created a strong fear of inflation -- increases in the overall level of prices. As a result, government leaders came to concentrate more on controlling inflation than on combating recession by limiting spending, resisting tax cuts, and reining in growth in the money supply.

Ideas about the best tools for stabilizing the economy changed substantially between the 1960s and the 1990s. In the 1960s, government had great faith in fiscal policy -- manipulation of government revenues to influence the economy. Since spending and taxes are controlled by the president and the Congress, these elected officials played a leading role in directing the economy. A period of high inflation, high unemployment, and huge government deficits weakened confidence in fiscal policy as a tool for regulating the overall pace of economic activity. Instead, monetary policy -- controlling the nation's money supply through such devices as interest rates -- assumed growing prominence. Monetary policy is directed by the nation's central bank, known as the Federal Reserve Board, with considerable independence from the president and the Congress.

Next Article: Regulation and Control in the U.S. Economy

This article is adapted from the book "Outline of the U.S. Economy" by Conte and Carr and has been adapted with permission from the U.S. Department of State.