Government's role in managing the economy

Government Economy

Government intervention in the economy takes a number of different forms -- tax policy, fiscal policy, trade policy and monetary policy among them. Even among free market democracies, governments are highly involved in the economy. Given that most central governments only have minimal control over central banks, monetary policy will be ignored for this discussion.

Trade and taxation policy are specifically designed to create a positive environment for economic growth. Trade policy is rooted in Ricardian trade theory based on the principles of comparative advantage, while taxation policy is often rooted in neoclassical economic theory, wherein taxation policy is one of the primary incentives by which humans determine the form that their economic activity undertakes. Both types of policy have been used extensively in recent decades, and both are often tailored to the needs of specific stakeholders. Trade policy has been the more effective of the two in the past couple of decades. Trade policies have shifted dramatically towards the reduction of trade barriers. While some industries and workers find themselves uncompetitive on global markets, opportunities are opened elsewhere in the economy. World trade has expanded rapidly since the first free trade pact came into force in the late 1980s between Canada and the United States. Dozens of other such pacts have been signed since, and successive rounds of WTO negotiations have seen tariffs and non-tariff barriers reduced significantly. Trade policies have increased investment flows, and ultimately have brought entire nations and tens of millions of people out of poverty (Lesher & Miroudot, 2006). The wealth level of the United States has seldom fallen in the past century, with PPP GDP increasing steadily over time.

Fiscal policy is more politically contentious, but the economics of using fiscal policy to manage the economy are clear-cut. The basic accounting identity of GDP = C + I + G + E -- M illustrates why fiscal policy is successful with respect to managing the economy, at least in the short-term (Leamer, no date). Government expenditures play a role in the size of the GDP, along with consumer spending, business investment and the trade balance. Government managing of the economic using fiscal policy typically amounts to spending more, as governments rarely use fiscal policy to slow an overheated economy, preferring to rely on the more effective monetary policy tools that central banks have at their disposal. An increase in government spending provides a short-term boost to the economy. If the money is spent on investments for future growth such as transportation infrastructure and education, then the impacts will be long-term positive as well. There is the risk that active management of the economy through fiscal policy will be insufficient, or that it will have long-term negative impacts if the government borrows too much to pay for the spending.