The Government's Role in the Economy

Using Fiscal and Monetary Policies to Regulate Economic Activity

The Great Depression
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In the narrowest sense, the government's involvement in the economy is to help correct market failures, or situations in which private markets cannot maximize the value that they could create for society. This includes providing public goods, internalizing externalities (consequences of economic activities on unrelated third parties), and enforcing competition. That being said, many societies have accepted a broader involvement of government in a capitalist economy.

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

Promoting Stabilization and Growth

Perhaps most important, 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 (known as fiscal policy) or managing the money supply and controlling the use of credit (known as monetary policy), it can slow down or speed up the economy's rate of growth and, in the process, affect 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 often defined as two consecutive quarters of decline in the gross domestic product, or GDP—were viewed as the greatest of economic threats. When the danger of recession appeared most serious, the government sought to strengthen the economy by spending heavily itself or by 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, which is an increase 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.

A New Plan for Stabilizing the Economy

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, or the 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 a growing involvement.

Monetary policy is directed by the nation's central bank, known as the Federal Reserve Board, which has considerable independence from the president and the Congress. The "Fed" was created in 1913 in the belief that centralized, regulated control of the nation’s monetary system would help alleviate or prevent financial crises such as the Panic of 1907, which started with a failed attempt to corner the market on the stock of the United Copper Co. and triggered a run on bank withdrawals and the bankruptcy of financial institutions nationwide.

Source: "Outline of the U.S. Economy" by Christopher Conte and Albert R. Carr, with permission from the U.S. Department of State