The economy is controlled by two types of policy:
- Fiscal (by Government): Taxes and Expenditures
- Monetary (by Central Bank): Money supply and Interest rate
Fiscal Policies
Government spending and taxes are the main tools used to control the level of economic activities (according to the Keynesian school).
To increase the level of economic activity:
- Increase government expenditure
- Decrease taxes
In equilibrium:
- Government Expenditure + Investment Expenditure = Taxes + Savings
- Any variation of this will cause inflation or unemployment.
Trade-off in Keynesian Model
There is a trade-off between unemployment and inflation.
- Stagflation: In the late 60s and 70s, the US experienced both high inflation and high unemployment due to increased government expenditure, oil shocks, and heavy international competition.The
- Keynesian model can only solve half of this problem (either inflation or unemployment, but not both)
- Fixes: Monetarists suggest that a severe short-term recession with the high-interest rates can fix the stagflation
Monetary Policies
Investment behavior depends on interest rates:
- Higher interest rates discourage investment
- Low-interest rates encourage investment
The central bank (such as the Federal Reserves in the US) can influence investment by changing interest rates.
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