How does government intervention impact economic growth and stability?
Research paper by Ananya Jain
Government intervention in the economy has been a subject of debate among economists and policymakers for quite some time. There is still controversy over the extent to which governments should intervene to promote economic goals such as growth, stability, and social welfare (Tanzi, 2011). While some argue that government involvement through fiscal policy, monetary policy, and regulation is essential to address market failures, stabilize the business cycle, and encourage long-term growth (Stiglitz, 2010), others believe that excessive intervention can distort market incentives, displace private investment, and result in inefficiency and slower growth over time (Friedman, 1982).
In the past, mixed economies that incorporated government intervention and free markets have successfully achieved sustained growth and stability (Samuelson & Nordhaus, 2009). However, the optimal level of intervention may vary depending on the country and economic circumstances. As Krugman (2012) points out, “the appropriate role of the government in the economy isn’t fixed, but depends on changing circumstances” (p. 91). To shed light on this complex and important issue, this paper will explore the theoretical arguments and empirical evidence regarding how government intervention impacts key economic outcomes.
In the past, mixed economies that incorporated government intervention and free markets have successfully achieved sustained growth and stability (Samuelson & Nordhaus, 2009). However, the optimal level of intervention may vary depending on the country and economic circumstances. As Krugman (2012) points out, “the appropriate role of the government in the economy isn’t fixed, but depends on changing circumstances” (p. 91). To shed light on this complex and important issue, this paper will explore the theoretical arguments and empirical evidence regarding how government intervention impacts key economic outcomes.
The government interventions can be for positive or negative externalities depending on the situation. An externality occurs when the actions of consumers or producers give rise to negative or positive side-effects on other people who are not part of these actions, and whose interests are not taken into consideration. If the side effect is positive, the externality is considered to be positive but if the side effect is negative, the externality is considered to be negative. Price control is when the government sets a legal minimum price in case of price ceiling and legal maximum price in case of price floor, for a good above or below the market equilibrium to either make it available for low income groups of people or to help the farmers or consumers.
The same has been illustrated in Fig 1
Subsidies are incentives a government gives businesses or individuals through grants, tax breaks, or cash to increase the supply of specific goods and services. Indirect taxes are imposed on spending to buy goods and services. They are paid partly by consumers but are paid to the government by producers. The government intervenes to correct market failure.
Market failure refers to the inability of the market to allocate resources efficiently. Negative and positive externalities of production and consumption cause market failure which if not corrected, can cause adverse effects to the economy of the world. Negative production externalities refer to external costs created by producers. The problem of environmental pollution, created as a side-effect of production activities, is very commonly analysed as a negative production externality. Government intervention indirect tax can be used to correct this externality. Negative consumption externality refers to external costs created by the consumers, which government regulations and legislation can correct
Market failure occurs when the marginal benefit is not equal to the marginal cost, leading to the decline in the availability of a good or service. To correct this, the government intervenes and moves production levels closer to their efficient quantities.
That agenda includes government efforts, such as mandatory contributions to pension plans, to encourage domestic capital accumulation and reduce dependence on more volatile foreign capital. Governments can stimulate economic growth in many other ways. Companies in many outperforming economies face fewer regulatory and tax barriers compared with companies in other countries. This, in turn, encourages business creation and improved efficiency.
A well-designed tax policy has the potential to raise economic growth, but there are many stumbling blocks along the way and certainly no guarantee that all tax changes will improve economic performance. As the income of the individuals increases, the consumption of the good also increases. If the government increases income taxes, then the consumers disposable income, which is the income left after the consumers have paid the taxes will decrease, resulting in a fall in the spending of the consumers and the aggregate demand curve will shift leftwards. The leftward shift in the aggregate demand curve will result in a decrease in the real GDP hence the economic growth will fall. Increase in business tax also results in the fall of firms after tax profits and the firm will reduce its investment, therefore the real GDP will fall, hence the economic growth will also decrease.
Fig 2 reflects how tax is a source of revenue for the government.
On the other hand, if the government increases taxation on demerit goods, the country’s economic growth could increase. For example, a hike on tax for tobacco will ensure better human health, and reduce the burden on health care due to tobacco consumption. The tax on demerit goods will generate government revenue which could be used for better infrastructures or other projects, therefore resulting in economic growth or if the consumers spend less on demerit goods, they will invest their money in something better, therefore the economic growth will increase.
Rent controls are one of the most common price ceilings. The Canadian government intervened to control the rent prices by setting a price ceiling on them so that they become affordable for all. The Canadian government observed a constant increase in the rents of the apartments over the years which was making it difficult for the consumers to afford. The price ceiling leads to consumer surplus, meaning the price the consumers have to pay is less than the price they’re willing to pay. Consumer surplus eventually results in more disposable income for consumers. This extra income can be used for various other things, the consumer could invest the money in better technology etc, therefore the real GDP would increase and would result in economic growth.
Fig 3- Rent controls as price ceiling
An import quota infers the numerical limit set to determine the quantity of a commodity that can be imported into a country. It is a trade restriction that the government puts in place to minimise the importation of a particular commodity over a given period. When the government sets import quote, the consumption of domestic goods increases because the price of international commodities has increased. Therefore the consumers switch to domestic goods resulting in an increase in the real GDP and therefore economic growth.
Empirical evidence of the same effects:
In response to the economic challenges caused by the COVID-19 pandemic, governments across the world took extensive measures. For example, the US government passed the CARES Act, which provided stimulus checks, enhanced unemployment benefits, and loans to businesses, amounting to $2.2 trillion. While these interventions helped to stabilize the economy and prevent a severe recession, concerns were raised about their long-term impact on inflation and debt sustainability.
Following the 2008 financial crisis, central banks such as the U.S. Federal Reserve implemented a strategy called Quantitative Easing (QE) by purchasing large amounts of assets to lower long-term interest rates and stimulate economic growth. Although QE helped to stabilize financial markets and support the economic recovery, some experts argue that it also worsened inequality in wealth distribution and increased the likelihood of asset bubbles.
Since 1978, the Chinese government has been involved in promoting specific industries and technologies through subsidies, state-owned enterprises, and strategic plans such as “Made in China 2025”. Although this approach has helped China’s economy grow quickly, it has also caused worries about market imbalances, excess production, and trade disputes with other nations.
Many governments establish minimum wage laws to ensure workers’ basic standard of living. In 2021, the U.S. government sought to increase the federal minimum wage to $15 per hour as part of the COVID-19 relief package, but it was not included in the final bill. Supporters claim that higher minimum wages encourage consumer spending and decrease poverty, while critics caution about the possibility of job losses and inflation. (Card & Krueger, 2015).
These examples illustrate the complex trade-offs involved in government intervention and the ongoing debates about its impact on economic outcomes in different contexts.
So how do we relate this to economic growth?
Economic growth refers to an increase in the production and consumption of goods and services. This increase in production and consumption is typically measured by the growth rate of a country’s gross domestic product. It is essential for a country as it helps to improve living standards, it creates opportunities for businesses to expand and also creates employment opportunities, all of which help in the growth of the country as a whole. Economic growth is challenging to measure but gross domestic product acts as an indicator for growth or recession and is defined as the combined value of all goods and services produced within a country in a year.
In light of global financial crises, a declining economy, rising inflation, and geopolitical uncertainty, adopting a holistic approach to achieve economic growth is crucial. This approach should include a bold mindset, enabling factors within the organization, and clear growth initiatives. Companies seeking growth should prioritize profitable and fast-growing markets, while also leveraging their ownership advantages. Studies have shown that 80% of growth comes from a company’s core, with the remaining 20% from secondary expansions, though these figures may vary across sectors. Utilities, for instance, tend to generate growth from their core, while industrial sectors generate growth from secondary expansions. Companies with fast-growing core businesses can position themselves ahead of future trends by expanding into new areas, while those with slow-growing cores can offset slow growth through adjacent businesses. Economic growth can be achieved by increasing physical capital goods, improving technology, growing the labor force, and increasing human capital.
When countries implement measures to improve their effectiveness and encourage competition, they tend to experience the most robust and consistent growth. The role of government in the economy is crucial, as it responds to market failures through various means like nudging, choice architecture, or intervention.
For instance, governments may impose taxes on carbon emissions to discourage fossil fuel consumption and incentivize cleaner energy sources or provide subsidies and tax incentives for purchasing electric vehicles to reduce greenhouse gas emissions.
Other interventions include regulating the sale and marketing of tobacco products by implementing health warnings on packaging, restricting advertising, and banning smoking in public places to reduce tobacco consumption and associated health risks.
These examples showcase how governments can use a range of tools to shape consumption patterns and promote social welfare in areas like public health and environmental sustainability.
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