The Role of Government in Economy

Nowadays, there are debates on how far government should interfere with the economy. Government has played an impact on the economy with the purpose to maximize the well-being of society. What governments generally do is to assure the economy grows at a steady pace, increase level of employment and stabilize the price level. However, whether government should take active policies to interfere with economy or just let it grow naturally has raised widely discussion. This essay discusses the role of government by analyzing both thought of Keynes and Friedman and then prove the effectiveness of Friedman’s theory with historical examples. Firstly, the Great Depression of the 1930s has helped prove the importance of government’s intervention on the economy in the past. The Great Depression started with a decrease in stock prices in America and then quickly spread to most parts of the world (McElvaine, 1993, p 59). There was a tremendous decrease on the demand and global trade, followed by high unemployment rate. As a result, various measures were taken by governments worldwide in an attempt to accelerate the economy’s recovery and reduce the unemployment rate including stimulation on demand by spending much more than they took in (Fox, 2008, p 1). At the final several years of the Great Depression, Keynesian macroeconomic theory, which shows the importance of government’s role on the economy, has played an impact on interventionists’ policies. In Keynesian economics, when inefficient economic outcomes aroused from decisions of private sector, public sector needs to take active measures. By fiscal policy adjusting taxes and government spending and monetary policy which deals with the amount of money supplied and credit, government could help stabilize the economic growth rate, and then plays an impact on price level and employment rate in the process (Congdon, 2007, p 169). In the case of the Great Depression, Keynes said the low unemployment rate were the result of insufficient demand, thus intervention of government was important to run deficits, increase spending and/or cutting taxes, and so as to keep people fully employed (Aikins, 2009, p 403). However, the stagflation of 1970s has challenged Keynesian theory bringing debates on the intervention of government on the economy (Gittins, 2010, p 6). According to Bresiger (2009) it was the 1970s, economic growth was weak, resulting in rising unemployment that eventually reached double-digits. The easy-money policies, which financed huge budget deficits and were supported by political leaders, were then undertaken by the American central bank, in order to generate full employment. However, it also caused high inflation which began in late 1972 and didn't end until the early 1980s. The great inflation, and the recession that followed, wrecked many businesses and hurt countless individuals. As Bresiger (2009) concluded in his article that before inflation returned to low single digits, another brutal policy of tight money, including the acceptance of a recession would be expected, and meanwhile the unemployment rate would exceed 10%. Given the increasing skepticism towards usefulness of fiscal policy and its multiplier effects proposed by Keynesian theory, another macroeconomic policy named monetarism chiefly proposed by Milton Friedman has attracted growing supports (Issing, 2010, p 35). It was supported by Bernhut (2003) concerning monetary policy, emphasizing on the amounts of money that government should determine to supply in circulation. The theory of monetarism puts a stress on the benefits aroused from free market economics and weaknesses associated with government intervention on the economy (Congdon, 2007, p 200). The appropriate economic role for government is to manage the amount of money in circulation, so as to influence aggregate output in the short run and finally control the level of prices and inflation rate over longer periods. Particularly during the 1980s, some of the laissez-faire thoughts proposed by Friedman including monetary policy, privatization, deregulation and taxation, were used by governments (Congdon, 2007, p 202). After analyzing the thought of both Keynes and Friedman respectively, it may be better to give a comparison on the two theories in order to see what role government should take in the economy. As Issing (2010 p 1) says in his article, after the Great Depression, there was dominant belief on the Keynesian theory. However, the lessons obtained from the stagflation of 1970s, associated with Keynesian policies, are that unrestrained and neffectively planned intervention by government could give rise to market failure and adverse economic outcome (Aikins, 2009, p 405). The weakness of Keynesian theory was supported by Callaghan who stated that cutting taxes and boosting government spending during recession would inject higher inflation rate followed by higher rate of unemployment (Issing , 2010, p 2). On the contrary, rather than regarding insufficient demand as the key factor driven the Great Depression, Friedman argued it was largely caused by the Federal Reserve reducing the money supply. In the article, Issing (2010) plays an importance on the money by illustrating that ignoring monetary factors has led to the worst crisis since the Great Depression related to the asset price bubbles. Another example which helps prove the effectiveness of monetarism was given by Congdon (2007). When Margaret Thatcher won the 1979 general election in United Kingdom, Britain had several inflation for several year, with inflation rate rarely below 10%. Even worse, the rate had reached 27% by the time of the election. Thatcher implemented monetarism to control inflation, and successfully reduced the rate to 4% at 1983. There was a global recession at that time, and Thatcher's monetarist policies contributed to the success of fighting against the recession, meanwhile helped Britain become one of the nations which recover economic growth firstly. To sum up, this essay has examined two theories concerning about the role that government should take in economy. In Keynesian economy, fiscal policy is particularly an important tool that government should use when aggregate demand is not insufficient and keep full employment by running government deficit. Historical evidence has showed that it was not an efficient way to fight recession. Conversely the monetarism offers Keynesians a better view of monetary policy. It can be shown that the core ideology of monetarism can still work well today and monetary factors can not be neglected, thus government has a role to determine amount of money supplied as well as the volume of credit in all aspects, but not interfere with the economy unrestrainedly and ineffectively.