Chapter 16: Government and the Economy

Why Is Government Involved in the Economy?

• We continue to debate the proper role of the government in dealing with the economy.– At times, a less active government is seen

as more important.– However, a more active government may

seem necessary (e.g., airline industry bailout).

The Role of Government

• Managing the economy• Protecting the welfare and property of

individuals• Regulating competition• Providing public goods

Should Government Be Involved in the Economy?

• What are the main arguments in the debate over the proper role of the government in the economy?

Economic Theory

• Laissez-faire capitalism• Keynesians• Monetarists

Classical Economics

• Adam Smith and The Wealth of Nations• The government that governs least is the

government that governs best.• Government should not compete with the

private sector.

Keynesian Economics

• The Depression was the product of declining demand.

• Government could use deficit spending to fund programs to stimulate demand.

• Government should reduce spending once the economy recovers.

What Are the Goals of Economic Policy?

• Promote a strong and stable economy• Promote business development• Promote international trade• Regulate industrial relations• Protect the environment• Protect consumers

What Are the Tools of Economic Policy

• Monetary policy– Discount rate– Reserve requirement– Open market – Federal funds rate

• Fiscal policy– Taxation– Spending and budgeting

• Regulation and antitrust• Subsidies and contracts

Monetary and Fiscal Policy

• Taxes• Fiscal policy

– Budgeting and spending using subsidies and contracts

– Deficit spending• Monetary policy

– Use of credit and interest to control demand of money and consumption

Monetary Policy

• Monetary policy is exercised by the Federal Reserve Board.

• Monthly adjustments in the interest rate are designed to stabilize the inflation rate and promote a stable economy.

The Federal Reserve Board

• The Federal Reserve System was created in 1913– Federal Reserve Bank– Federal Reserve Board

• Chairman (four-year term)• Six governors (fourteen-year terms)

The Federal Reserve BoardMonetary Strategies

• Discount rate– The setting of interest on loans to member

banks• Open market operations

– The buying and selling of government securities• Reserve requirements

– The amount of liquid assets and ready cash that banks are required to hold to meet depositors’ demands

The Federal GovernmentOther Strategies

• Federal Funds Rate involves the interest rate on loans between banks.

• FDIC• FSLIC

Fiscal Policy

• Fiscal policy is generally exercised by the president and Congress.

• Taxing and spending levels are adjusted to affect the economy.

Taxes

• Taxes are used to redistribute money from one sector of society to another.

• Taxes can also be used to encourage or discourage certain types of behavior.

Taxation

• Tariffs• Sixteenth Amendment (1913)

– Authorizes Congress to tax incomes• Progressive taxation

– Income tax• Regressive taxation

– Sales tax– Social Security

Regulation

• Administrative regulations are rules made by regulatory agencies and commissions to control specific areas.– OSHA regulates workplace safety;

noncompliance may result in fines or other penalties.

Subsidies

• Subsidies are government grants of cash or other valuable commodities to promote certain activities.– Crop subsidies used to promote stable

crop levels

Contracts

• Contracts are agreements with individuals or firms in the private sector to purchase goods or services.– Military contracts used to develop

defense systems

The Politics of Economic Policy

• A healthy economy is the goal of both parties.

• However, differences exist as how best to achieve this objective in terms of political parties and interest groups.