Economic Growth and Public Policy

How important is politics for the economy? How does the government choose its public policy, and to what extent do they impact the overall economy? What are some of the industries that the government targets to ensure growth?

You will be able to answer all these questions once you read our explanation on "Public Policy and Economic Growth."

Public Policy and Economic Growth Definition

Public policy is the term for government actions intended to affect the public. It is a very broad term and encompasses virtually all significant roles of government, ranging from education to social welfare to law enforcement.

In terms of economics, public policy refers to areas that impact education, infrastructure development and maintenance, business regulations, law enforcement, and scientific and technical research. These factors combined affect economic growth.

What does economic growth mean? Economic growth means an increase in output, which is measured by gross domestic product (GDP). GDP is defined as the total value of all final goods and services produced within a nation during one year, with final goods meaning those sold to consumers (retail sale). The United States has a GDP of over $23 trillion!¹

However, economic growth typically takes two additional variables into account: Inflation and population. GDP is measured in current prices, which generally are higher than prices from the previous year. Therefore, GDP tends to rise every year, but that does not necessarily mean that more output was generated.

To account for rising prices, GDP is adjusted for inflation using the measurement of real GDP. Real means adjusted for inflation in finance and economics - keeping prices the same. An increase in real GDP means more output generated than the previous year.

An increase in real GDP constitutes economic growth, but policymakers tend to search for a final refinement: is there more output generated per person in the economy? The term for “per person” in finance and economics is per capita. Dividing real GDP by the size of the population reveals per capita real GDP or the average amount of output produced per person in the economy.

Real GDP per capita and economic growth are affected by public policies that impact labor force participation and productivity. The reason for that is that these two factors directly impact the number of goods and services that can be produced in the economy.

Figure 1. Production Possibilities Curves and Economics Growth, StudySmarter Originals

Figure 1 illustrates production possibilities curves that are used to demonstrate economic growth. When the economy is experiencing economic growth, production possibilities curves result in an outward shift. In this case, we have computers and wheat, and an outward change would mean that more wheat and computers can be produced in the economy. However, when there is a fall in economic growth, the production possibilities curves shift to the left.

Most government policies are intended to assist with economic growth, either through ensuring fair competition, minimizing harmful negative externalities that reduce the quantity and quality of factors of production, or improving business conditions. Historically, however, this public policy was rather limited. Since the Great Depression of the 1930s, the government began actively monitoring and encouraging economic growth through regulatory, fiscal, and monetary policies.

It is hard to argue whether there is a positive or a negative relationship between public policy and economic growth. That is because governments don't continuously pursue the right public policy or the most efficient one. However, given that the government uses the right regulatory policy, fiscal policy, or monetary policy, economic growth will be positively impacted.

Impact of Government Policies on Economic Growth

The impact of government policies on economic growth is huge. Local, state, and federal government policies can significantly impact economic growth. The government promotes economic growth by influencing the three major components of long-term economic growth: human capital, physical capital, and technological progress.

Governments and Human Capital

Education policies, primarily enacted at the state level in the United States, affect the quality and quantity of both labor and entrepreneurial ability. Increased public funding for education boosts economic growth by improving the labor force - both through higher quality workers and a higher labor force participation rate - and growing innovation.

Governments and Physical Capital

The government spends tons of money on building infrastructure, which makes it easier to transport goods and services across the country. Additionally, as the government builds new roads and connects states, there's a higher chance of increasing the trading volume between these states. As the trading volume between states increases, investment spending will increase, as there will be new business opportunities.

Governments and Technology

Government policy that invests in technology affects economic growth. Government grants and contracts to private-sector producers spur innovation through fair competition. People will exercise and refine their entrepreneurial ability to compete for government grants, funding, prizes, and contracts. Companies that produce the best products and services can win lucrative government contracts to do business with city governments, school districts, colleges and universities, state governments, the military, and federal government agencies. This boosts economic growth because the innovative efforts used to win government contracts also go to produce goods and services more efficiently for the civilian market. Additionally, the government uses its resources on R&D, which helps discover technologies that will contribute to long-term economic growth.

Governments and Political Stability and Property Rights

Resource conservation policies, which occur at all levels of government, affect economic growth by ensuring a continued supply of high-quality natural resources. These include government regulations on everything from air pollution to strip mining to commercial fishing. Regulations prevent overuse or destruction of resources, minimizing the Tragedy of the Commons scenario in economics. The Tragedy of the Commons scenario takes place when there is overconsumption and underinvestment, which in turn depletes available resources to the detriment of all. When costs of any economic production cannot be limited to the producer and consumer and affect third parties, a negative externality is generated, and the government steps in to regulate and ensure fairness.

Fiscal Policy for Economic Growth

Fiscal policy for economic growth consists of government spending and taxation. The government can directly spend money on infrastructure, education, and scientific and technical research. This boosts economic growth in the short term by increasing aggregate demand or the total amount of spending. In the long run, completed infrastructure projects, higher levels of citizen education, and scientific and technical breakthroughs can foster a higher level of economic output by increasing a nation’s production capacity.

When the Great Depression hit in the early 1930s, the federal government began promoting infrastructure spending for the purpose of economic stimulation and unemployment reduction. This was popularized by the works of British economist John Maynard Keynes. He declared that government spending could be used to increase economic output and reduce unemployment during economic recessions without causing excessive inflation.

Expansionary fiscal policy is used during recessions, such as the Great Depression, and involves increasing government spending and/or reducing taxes. This increases aggregate demand, as either the government is actively pumping money into the economy or people and businesses are diverting money that would have gone to pay taxes into more spending. Between the 1930s and the 1960s, the U.S. government favored high government spending to maintain high aggregate demand, keeping unemployment low.

Supply-side fiscal policies focus on cutting taxes to boost economic growth. Short-run supply-side fiscal policies affect aggregate demand, aggregate supply, and potential output. In the long term, supply-side fiscal policies affect household and business economic behavior.

During periods of high inflation, contractionary fiscal policy is used to reduce total spending in the economy. This consists of reduced government spending and/or higher taxes. While this can effectively reduce inflation, it may trigger a recession and higher unemployment. Thus, contractionary fiscal policy is often unpopular! Instead, the government prefers to use a less political approach to combating inflation that does not involve having to pick which groups or programs suffer from funding cuts or paying higher taxes.

Monetary Policy for Economic Growth

Monetary policy for economic growth is conducted by a non-partisan institution called the Federal Reserve System, often known simply as “the Fed.” As a regulatory agency, the Fed is independent of Congress or the President and is focused on two goals: Maintaining a low rate of inflation and full employment (roughly 5 percent unemployment or less, meaning no unemployment linked to a recession). The Fed pursues economic growth by adjusting the money supply, which raises or lowers interest rates across the banking system.

When the economy is in a recession and the Fed wants to spur economic growth, it tries to lower interest rates by increasing the money supply. It does so by adjusting its three monetary policy tools: the purchase of government bonds, which is dictated by setting a target range for the overnight Fed Funds Rate (the rate at which banks borrow from each other), the Fed-controlled interest rate for banks known as the discount rate (the rate at which banks borrow from the Fed), and the reserve requirement ratio that sets what percent of all deposits in banks must be kept as cash and not loaned out. To fight a recession and conduct an easy money policy, the Fed will buy bonds (to give bond-holders cash), lower the discount rate (to make it easier for banks to borrow from the Fed), and lower the reserve requirement (to free up more of depositors’ money for lending).

Conversely, when inflation is too high, and the Fed wants to reduce spending, it will reverse its three tools. To pull money out of the economy, the Fed will sell bonds (in exchange for cash), raise the discount rate (to make it harder for banks to borrow from the Fed), and raise the reserve requirement (to “lock-up” more of depositors’ money so it cannot be loaned). While a tight money policy is not popular, it is often preferable to a contractionary fiscal policy. Raising interest rates by reducing the money supply allows natural market forces to determine which prospective borrowers decide not to borrow. Thus, in theory, more competitive borrowers will still be able to borrow and invest, maintaining the most efficient economic production.

Fiscal Policy and Monetary Policy Examples

Fiscal policy examples include government infrastructure projects like highways, ports, courthouses, schools, and energy/utility plants. These boost the economy immediately through increased aggregate demand and permanently through increased production capacity. The New Deal during the 1930s under President Franklin D. Roosevelt is a classic example of expansionary fiscal policy. Tax cuts under Presidents Ronald Reagan and Donald Trump are also examples of expansionary fiscal policy, as they freed up money to be spent by businesses and consumers.

Monetary policy examples are seen during recent recessions, where the Federal Reserve lowered interest rates to encourage borrowing. Currently, in spring 2022, the Fed is raising interest rates to combat inflation. It does this by setting a target interest rate and then adjusting its monetary policy tools until interest rates rise or fall (in this case, rise) to that target. The higher interest rate will reduce consumer spending by affecting household behavior: with higher interest rates, households will take out fewer loans to buy new cars, appliances, furniture, and other expensive items.