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8.6 Government and the Economy

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Understand why governments make economic policy.
  2. Understand the importance of productivity.

Why would government want to get involved in the economy? Nearly every government—conservative or liberal, managed or market-driven—has the same objective: Creating the conditions whereby people can live materially satisfying lives. (As I explained to students in China once, people all over pretty much want the same things: Food, clothing, a roof over their heads, maybe some nice clothes to look pretty on the weekend.) Consequently, most governments typically have three goals in terms of economic management: full employment, price stability and economic growth. If citizens have jobs, they’re happier; if prices are rising too fast, they’re less happy. Growth allows these things to happen even as population grows, and also means higher standards of living. Growth sometimes gets a bad name, though it doesn’t necessarily mean that the suburbs are sprawling across the forests, fields and farms. Full employmentAn employment rate in which everybody who wants a job has one., meanwhile, doesn’t mean zero unemployment. It means that everybody who wants a job has one. In practical terms, that means 3–4 percent unemployment, as some people will be between jobs and some people may be just taking a break. Price stability means a relatively low level of inflation, say, under 3 percent. And if the economy is doing well, the party in power gets the credit and gets to stay in office a while longer.

Economic growthAn increase in the output of goods and services. is an increase in the output of goods and services. It tends to mean more jobs and higher incomes for people, and also access to goods and services on which to spend that income. It’s worth noting that there are in fact only two sources of economic growth: gains in population, and gains in productivity. Gains in population tend to mean an increase in demand, which drives up prices and encourages more supply. Firms hire more workers, who have more income to spend on themselves and their families. Gains in population, however, also generate externalities—more pollution, less open space, more traffic, higher housing prices (a great thing if you’re selling a house, not such a good thing if you’re buying one).

Aside from Chairman Mao in China after World War II, governments typically no longer actively encourage population growth as a matter of policy. Population tends to grow when times are better, as people can afford families, such as during the Baby Boom that followed the post-World War II economic expansion in the United States. In more recent times, however, in industrialized nations such as the U.S., Japan and Europe, birth rates have fallen. Whereas in agricultural societies more children can mean more farmhands, in industrial societies children are an expense. A couple of kids is good; a bunch can get kind of spendy.


The key to economic growth is gains in productivityOutput per worker., and governments do try to actively encourage that. Productivity is output per worker. It’s very important—you can track the ups and downs of the U.S. economy by watching what productivity is doing. Slow or no growth in productivity means lower profits for businesses, and when business profits are down, they hire fewer people and pay the people they have less money. Why is this so important? If a worker is more productive—produces more goods per hour worked—production costs fall and profits rise. Gains in productivity mean that you’re producing a greater number of widgets with the same resources. That means higher profits, which usually means greater wealth for more people.

Gains in productivity come from better skills; better equipment and/or processes (including specialization of labor); finding new sources of natural resources; innovation (a change in the way resources are used); or eliminating waste. Steel plows, for example, greatly improved the productivity of agriculture by allowing the plowing of more land. (Before this, plows were usually made of wood, which meant they couldn’t break up the ground of many kinds of soil to allow planting.) In another example, prices fell throughout the 1800s with the rise of the industrial revolution, despite gains in wealth and population (which usually drives up prices). More goods were produced by machine instead of by hand, so output increased even as prices fell.

Because there are limits to everything, and technological innovation is unpredictable and tends to plateau, improvements in productivity can’t just be ordered up from Productivity in the U.S. soared after World War II, but then flattened in the 1970s. Productivity turned up again in the 1990s, and the economy boomed, but that boom didn’t survive the 2000s.

Any way you look at it, productivity is one of the keys to economic success. So part of the question we need to answer is, how do government policies foster or discourage productivity?

Key Takeaways

  • Most governments want to achieve economic growth, full employment and stable prices.
  • Gains in productivity a major source of economic growth.


  1. Think about where you work, or have worked. What kinds of things might affect the productivity of the business and workers there?
  2. How could a nation grow its economy without driving up prices (inflation)?