Government decisions to adopt new policies are frequently influenced by economic situations. Government policy has historically had a significant impact on economic growth, the emergence of new company entities, and the success of financial markets, particularly in the United States.
A nation’s economic activity, in the broadest sense, reflects what its citizens, companies, and governments wish to buy and sell. Theoretically, the decisions made by customers and producers are what essentially shape the economy because the U.S. has a capitalist system that is based on the ideas of a free market.
Exactly why do governments step in?
To engineer economic growth or avert unfavorable economic situations in the future, the government may opt to restrict some parts of economic activity. In general, a government’s active involvement in addressing and influencing a nation’s economic conditions serves to protect and advance the economic interests of the general population.
Having a track record of economic growth is frequently a key factor for those in political power (especially if they are in a position of seeking re-election). Numerous studies in the United States have revealed that the economy has a significant impact on how individuals vote (specifically in the U.S. presidential election).
Stronger pay growth, more jobs created, improved financial market performance, and larger corporate profits are all often results of robust economic growth.
How Do Governments React to the Economy?
Fiscal policy and monetary policy are the two major methods that the federal government may react to economic activity in order to ensure robust economic growth.
Changing the cost of borrowing money is one of the most frequent ways a government may try to affect a nation’s economic operations. It can be decreased or increased. In order to limit economic growth, the Federal Reserve raises the federal funds rate, and in order to promote it, it lowers the federal funds rate.
The Federal Reserve’s purchases and sales of government securities represent another aspect of monetary policy. When the Fed purchases a security from a bank, it injects money into that bank, expanding the money supply. It can also sell securities to remove cash and reduce the amount of money in circulation.
Tax incentives, increased tax credits, and tax rate reductions all lessen the financial burden on citizens while fostering economic expansion. Economic activity is slowed down when favorable tax rules are repealed or taxes are raised.
The System of Federal Reserve
The Federal Reserve System in the United States oversees the nation’s monetary policy. The American central bank is known as the Federal Reserve System or simply “the Fed.” The Federal Reserve System (Fed), which Congress established in 1913, manages the money supply and actively utilizes policy to react to and affect the state of the economy.
The interest rate that banks charge one another to borrow money is adjusted by the Fed. (This expense is subsequently borne by consumers.) To keep borrowing affordable, guarantee that credit is readily available, and increase consumer (and corporate) confidence, the Fed may cut the interest rate. On the other hand, in a robust economy or in reaction to inflation worries, the Fed might opt to boost interest rates. Inflation is the rise in prices that happens when individuals have more money to spend than what is available to buy.
You’ll see that the Federal Reserve, an autonomous organization that officially is not a part of the Federal government, sets monetary policy in the context of the two ways governments might engage in the economy. Contrarily, fiscal policy necessitates majority support and political intervention (for items not issued by executive order by the President).
Bringing About Financial Stability in the American Economy
Massive bank failures and corporate bankruptcies had caused numerous major economic disruptions in the U.S. before the Fed was established in 1913. The Fed was established with the responsibility of ensuring the financial stability of the American economy.
Following the Great Depression, recessionary periods—a time of poor economic growth and high unemployment rates—posed the biggest threat to the stability of the American economy. These two elements working together resulted in a continuous period of the gross domestic product declining (GDP). The government responded by increasing its own spending, lowering taxes (to encourage consumers to spend more), and expanding the money supply (which also encouraged more spending).
The 1970s saw the emergence of a new economic reality. This booming economy with a significant increase in the money supply resulted in a prolonged period of high inflation. The U.S. government started concentrating more on controlling inflation as a result of these economic causes, shifting its attention away from fighting the recession. As a result, the government passed laws that restricted the increase of the money supply, cut back on tax cuts, and restrained government spending.