The economy is controlled by two policies:
- Fiscal (by Government): Taxes and Expenditures
- Monetary (by Central Bank): Money supply and Interest rate
THE FOLLOWING NOTES ARE THE BASIC CONCEPTS IN THE MAINSTREAM (CAPITALISTIC, NEO-CLASSICAL) ECONOMICS.
Government spending and Taxes are the main weapon to control the level of economic activities (by Keynesian school).
To increase the level of economic activity:
- Increase Government expenditure
- Decrease taxes
In the 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 high inflation and high unemployment due to the increased government expenditure, oil shock, and heavy international competition.
- Keynesian model can only solve half of the problem (inflation or unemployment, not both)
- Fixes: Monetarists suggests that the severe short-term recession with the high-interest rates can fix the stagflation
Investment behavior depends on interest rates.
- Higher interest rates discourage investment
- Low-interest rates encourage investment
The central bank (such as Federal Reserves in the US) can influence investment by changing interest rates.