What Impact Does Economics Have on Government Policy?

Economic conditions often inform the policy changes that governments elect to enact. Specifically in the United States, government policy has always had a large amount of influence on economic growth, the creation of new business entities, and the success of financial markets.

In the broadest sense, a country's economic activity reflects what people, businesses, and governments want to buy and what they want to sell. Because the U.S. has a capitalist economy that relies on the principles of a free market, theoretically, it is primarily the decisions of consumers and producers that mold the economy.

Key Takeaways

  • Economic conditions often inform the policy changes that governments elect to enact.
  • In the U.S., government policy has always had a large amount of influence on economic growth and the creation of new business entities.
  • For those in political power, having a track record of economic growth is often an important consideration (especially if they are in a position of seeking re-election).
  • To ensure strong economic growth, there are two main ways that the federal government may respond to economic activity: fiscal policy and monetary policy.
  • In the U.S., the Federal Reserve System directs the country's monetary policy.

Why Do Governments Intervene?

The government may decide to regulate some aspects of economic activity in order to engineer economic growth or prevent negative economic conditions in the future. In general, a government's active role in responding to and influencing the economic circumstances of a country is for the purpose of preserving and furthering the economic interests of the general public.

For those in political power, having a track record of economic growth is often an important consideration (especially if they are in a position of seeking re-election). In the U.S., many studies have shown that the economy is a major factor that affects how people vote (specifically in the U.S. presidential election). Strong economic growth typically translates to high job creation, stronger wage growth, better financial market performance, and higher corporate profits.

How Do Governments Respond to Economic Activity?

To ensure strong economic growth, there are two main ways that the federal government may respond to economic activity: fiscal policy and monetary policy.

Monetary Policy

One of the most common ways that a government may attempt to influence a country's economic activities is by adjusting the cost of borrowing money. This is most often done by lowering or raising the federal funds rate, a target interest rate that impacts short-term rates on debt such as consumer loans and credit cards. The Federal Reserve increases the federal funds rate to constrict economic growth and decreases the federal funds rate to encourage economic growth.

Another form of monetary policy is the act of the Federal Reserve buying and selling government securities. When the Fed buys a security from a bank, it increases the money supply by injecting funds into that bank. Alternatively, it can sell securities to remove cash and decrease the money supply.

Monetary Policy Example

In response to the COVID-19 pandemic, the Federal Reserve quickly reduced the federal funds rate to 0%. By setting prevailing interest rates very low, the Federal Reserve attempted to support economic activity, maximize employment, and meet price stability goals.

Fiscal Policy

The government may also enact policies that adjust spending, change tax rates, or introduce tax incentives. In regards to government budgets, the government identifies whether or not it wants to spend more money than it anticipates collecting. This process of evaluating public spending aims to promote economic prosperity or cool an overheated economy.

Instead of focusing on how the government spends money, common fiscal policy revolves around how the government collects money. Offering tax incentives, additional tax credits, or lowering tax rates decreases the economic burden on citizens and promotes economic growth. Striking down favorable tax laws or increasing taxes slows economic activity.

Fiscal Policy Example

In response to the COVID-19 pandemic, the Federal government awarded economic impact payments (i.e. stimulus checks) to qualifying Americans. The government directly sent eligible individuals money to promote economic activity and encourage household spending.

Fiscal and monetary policies are both intended to either slow down or ramp up the speed of the economy's rate of growth. This, in turn, can impact the level of prices and the employment rate in the country. However, there's subtle differences between these two types of government action.

Differences Between Government Policies

Monetary Policy
  • Change in the money supply or how easy credit is to obtain

  • Adjustment in federal funds interest rates or money supply

  • Set by Central Bank

  • Heavily independent of the political process

  • Impacts debt industries like housing market

Fiscal Policy
  • Change in how the existing monetary supply is utilized

  • Adjustments in government spending and tax rates

  • Set by Federal Government

  • Heavily integrated with political process

  • Impacts government budgets/net deficits or

The Federal Reserve System

In the U.S., the Federal Reserve System directs the country's monetary policy. The Federal Reserve System—also called "the Fed"—is the central bank of the United States. Established in 1913 by Congress, the Fed controls the money supply and actively uses policy to respond to and influence economic conditions.

The Fed adjusts the interest rate that banks charge to borrow from one another. (This cost is then passed onto consumers.) The Fed may lower the interest rate to keep borrowing cheap, ensure that credit is widely available, and boost consumer (and business) confidence. Conversely, the Fed may decide to raise interest rates in a strong economy, or in response to inflation concerns—the increase in prices that occurs when people have more to spend than what's available to buy.

In the two ways governments can intervene in the economy, you'll note that monetary policy is set by the Federal Reserve, an independent entity technically not part of the Federal government. On the other hand, fiscal policy requires political intervention and majority approval (for items not issued by executive order by the President).

Achieving Financial Stability in the U.S. Economy

Prior to the creation of the Fed in 1913, the U.S. had experienced several severe economic disruptions as a result of massive bank failures and business bankruptcies. As an institution, the Fed was tasked with ensuring financial stability in the U.S. economy.

After the Great Depression, the greatest threat to the stability of the U.S. economy were recessionary periods: periods of slow economic growth and high unemployment rates. In combination, these two factors created a sustained period of decline in the gross domestic product (GDP). In response to this, the government increased its own spending, cut taxes (in order to encourage consumers to spend more), and increased the money supply (which also encouraged more spending).

Beginning in the 1970s, a different economic reality emerged. This expansionary economy with substantial money supply growth led to a sustained period of high level of inflation. In response to these economic factors, the U.S. government started focusing less on combating recession and more on controlling inflation. Thus, the government enacted policies that limited government spending, reduced tax cuts, and limited growth in the money supply.

At this time, the government also shifted away from its reliance on fiscal policy—the manipulation of government revenues to influence the economy. The fiscal policy did not prove effective at addressing high levels of inflation, high levels of unemployment, and vast government deficits. Instead, the government turned to monetary policy—controlling the nation's money supply through such devices as interest rates—in order to regulate the overall pace of economic activity.

Since the 1970s, the two main goals of the Fed have been to achieve maximum employment in the U.S. and to maintain a stable inflation rate. This dual mandate is difficult to achieve; by combating one of the goals, it becomes more difficult to fight the other.

While outside events may influence economic activity, governments use economic means to enact changes as they see fit. This may include changes to tax policy, adjustments to the federal funds rate, fluctuations in the money supply, or alternations to government spending.

Should the Government Intervene in the Economy?

Whether or not the government should intervene in the economy is a deeply-rooted philosophical question. Some believe it is the government's responsibility to protect its citizens from economic hardship. Others believe the natural course of free markets and free trade will self-regulate as it is supposed to.

Why Might the Government Intervene in the Economy?

The government has an inherent interest in protecting the well-being of its citizens. Due to prevailing conditions in the world, the government might see fit to enact certain legislation to preserve the quality of life for its citizens. The government might also enact legislation to promote economic well-being and equity across different socioeconomic classes.

What Are Some Ways the Government Intervenes in the Economy?

The government has two primary ways of interacting with the economy. Through monetary policy, the government controls prevailing interest rates and makes obtaining debt easier or harder. Through fiscal policy, the government controls spending levels and how to allocate resources.

Article Sources
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  3. Internal Revenue Service. "Economic impact payments: What you need to know."

  4. Board of Governors of the Federal Reserve System. "What is the Purpose of the Federal Reserve System?"