Overview: Government’s Role in the Economy

What It Means

Over the course of history some governments have attempted to exercise complete control over economic affairs in the interest of accomplishing social or political goals, and other governments have attempted to stay completely out of economic affairs in the belief that economies work best when they are unregulated. Today the roles that most governments play in their national economies fall somewhere between these two extremes.

Most of the world’s largest economies today are capitalist; that is, they are systems allowing individuals and businesses to own property and compete with one another in the pursuit of profits and economic well-being. In a capitalist economy producers and consumers make countless individual decisions that together add up to the bigger economic picture. No central authority dictates what goods and services companies produce or sets prices for those goods and services. Instead, the competing forces of sellers (supply) and buyers (demand) result in prices that ultimately dictate what will be produced, how it will be produced and distributed, and who will enjoy the fruits of this production and distribution.

In the United States more than in most countries, people tend to believe that the economy should be shaped by the competing interests of individual businesses and consumers, rather than by government decrees and plans. It is true that governments at the local, state, and national levels in the United States intervene in economic affairs less than their counterparts in many other countries, but they nevertheless play an important role in, and have the power to monumentally alter, the national economy. While local and state governments can have a significant affect on their economies, at the national level the federal government has far more power to alter the economic landscape.

The U.S. government’s role in the economy can be broken down into two basic sets of functions: it attempts to promote economic stability and growth, and it attempts to regulate and control the economy. Its tools for promoting stability and growth are fiscal policy (alterations in tax rates and spending programs) and monetary policy (alterations in the amount of money in circulation). The federal government regulates and controls the economy through numerous laws affecting economic activity. These range from laws enforcing private property rights to laws promoting competition among businesses.

When Did It Begin

Aside from the establishment and enforcement of private property rights, which are essential to any capitalist economy (an economy in which businesses and individuals are allowed to compete freely in the pursuit of their own economic well-being), the U.S. government, like its European counterparts, did little to regulate its economy during the eighteenth century and most of the nineteenth. The federal government’s hands-off approach to the economy was in keeping with the views of early economists such as Adam Smith (1723–90), who believed that a government best promoted economic well-being when it stayed out of economic affairs. By the late nineteenth century, however, the inhumane conditions to which the increasingly large working class was subjected in the factories and mines of Europe and America led to increased government regulation of industry.

The first two decades of the twentieth century saw the United States, under Presidents Theodore Roosevelt (1901–09) and Woodrow Wilson (1913–21), more heavily enforce existing industrial regulations and pass new ones, including laws creating many of the regulatory bodies (such as the Food and Drug Administration, the Federal Trade Commission, and the Interstate Commerce Commission) that still regulate businesses today.

Government involvement in the economy became much more pronounced, however, in the aftermath of the Great Depression, the severe economic crisis that crippled the world economy and left approximately 25 percent of American workers jobless during the 1930s. As part of President Franklin D. Roosevelt’s (1933–45) New Deal, a set of government efforts meant to revitalize the economy, the federal government backed large-scale public-works projects that employed out-of-work Americans, and it began making transfer payments (direct financial aid) to citizens through such programs as Social Security, which benefits the elderly and the disabled. Both of these forms of spending had the effect of putting money in people–s pockets, which gave businesses an incentive to increase their activity, at the same time that the programs provided much-needed relief to those suffering the effects of unemployment. Additionally, the New Deal included the establishment of important regulatory bodies such as the Securities and Exchange Commission, which oversees the stock market, and the Federal Deposit Insurance Corporation, which insures people who deposit money in banks.

More Detailed Information

The U.S. government influences economic growth and stability through the use of fiscal policy (manipulating tax rates and spending programs) and monetary policy (manipulating the amount of money in circulation). It uses these tools with the intent of steering the economy toward conditions of steady growth, low unemployment, and stable prices.

Fiscal policy consists of alterations to tax rates and spending programs. These alterations are proposed and passed by the U.S. Congress and/or the President; as such, they are often subject to political priorities as much as economic ones. When the government raises taxes, money moves out of private hands and into government coffers. Thus, people have less money to spend, and they demand lesser quantities of products. Businesses produce less, and the economy slows. When the government cuts taxes, private citizens and businesses have more money to spend and invest, and this tends to spur economic growth. Likewise, government spending (on military equipment, education, scientific research, and transfer payments, for example) moves money out of government coffers and into private hands. This stimulates demand and encourages economic growth. Cuts in government spending have the opposite effect.

Monetary policy consists of alterations in the money supply. The central bank of the United States, the Federal Reserve System (often called the Fed), has the sole power to regulate the money supply, and it operates independently of the President and Congress, focusing on economic rather than political concerns. When more money is in circulation, the economy tends to grow. When the money supply is restricted, the economy tends to slow down. The Fed does not increase the size of the money supply simply by ordering more dollar bills printed. Instead, it primarily uses its influence over banks and other lending institutions to change the size of the money supply.

The money supply includes not simply coins and bills but also the bank-account balances against which people can write checks or make withdrawals. One group of people who possess this form of money is depositors, those who hand over their paychecks and other money to a bank for safe keeping. Banks do not simply store this money, though. They lend it out to borrowers, people and businesses who want to make large purchases, such as purchases of real estate or business equipment. When a bank loans money, the borrower is, like a depositor, given a bank account balance against which he or she can write checks or make withdrawals. By loaning money, then, a bank literally creates money: a borrower is given money to spend, in the form of an account balance, even though no new bills or coins have been minted.

When the Fed wants to increase or decrease the money supply, therefore, it lowers or raises interest rates, the fees that borrowers pay for the use of money. The lower interest rates fall, the more inclined people are to borrow money, and the more money banks put into circulation. The higher interest rates climb, the less inclined borrowers become to pay for the use of money, and the amount of money in circulation falls.

In addition to these active forms of intervention into the economy, the federal government has wide-ranging regulatory responsibilities over private businesses. Traditionally, the government has regulated industries such as utilities, where one company tends to have a monopoly (sole control over the industry) in a given region. The government has often set limits on prices to prevent utility monopolies from raising prices at will. Other industries have historically been subject to price controls. Examples include agricultural producers, trucking, and airlines.

The government has also, since the early twentieth century, sought to prevent monopolies from forming. In general, consumers and the economy as a whole benefit when there is a high level of competition in any industry. To compete with one another for customers, firms must price their goods fairly and produce high-quality products; when a company has a monopoly, on the other hand, it naturally tends to focus solely on assuring its own profits, regardless of the interests of consumers or economic efficiency. If two companies want to merge, but the resulting company threatens to become a monopoly, the government has the power to intervene to prevent the merger. Likewise, if two dominant companies conspire to keep prices artificially high, the government is empowered to intervene.

Social goals, such as consumer health and environmental protection, also serve as the basis for a substantial amount of government regulation. Government agencies monitor companies’ environmental impact, the safety of food and drug supplies, and workplace conditions.

Recent Trends

Having discovered during the Depression that fiscal policy could be effective at creating demand and stimulating the economy, the U.S. government primarily used fiscal policy to manage the economy and bring it through recessions (periods of slow economic growth typically accompanied by increased unemployment) in the following decades. Focusing so intently on lessening the impact of recessions (and on preventing depressions), the government perhaps paid less attention to inflation (the rising of prices across the economy) than was warranted. Out-of-control inflation in the 1970s threatened to dislocate the economy as badly as any recession, especially since it corresponded, as had never been the case before, with high unemployment.

Fiscal policies could do nothing to turn the tide of these problems, and economists began paying more attention to the effects of managing the money supply. Inflation was brought under control through a severe reduction of the money supply (which threw the country into recession in 1982), and has never since been a serious problem. Monetary policy, accordingly, has replaced fiscal policy as the government’s primary tool for shaping the economy.

The latter part of the twentieth century also saw a wave of deregulation. The relatively tight control that the government had exerted on the utility, transportation, and other industries was relaxed. This was partly due to concerns that government regulation prevented companies from responding to market forces in a way that would force them to innovate and remain efficient, and it was partly due to the appearance of new technologies in industries like communications, which allowed new companies to compete in fields such as telecommunications which had once tended naturally toward monopoly conditions.

More controversial was the tendency of the U.S. government, under conservative Presidents such as Ronald Reagan, whose term ran from 1981 to 1989, George H. W. Bush, who served from 1989 to 1993, and George W. Bush, 2001–09, to pursue the relaxation of regulation that had been proposed for social reasons. The Reagan and George W. Bush administrations were particularly aggressive at trying to eliminate environmental, workplace, and consumer protections.