Modern economic theory was first written down by the Scottish " Adam Smith " in his book " The Wealth of Nations " which was published in 1776 (the year Americans revolted against Brirtish rule & declared their independence).In his book Adam Smith advocated market economy based on the principle of "Laissez Faire" that is to say " non-government intervention" ...
Smith naively believed that Capitalism, as an economic system, wes blessed with a built-in "self-correcting mechanism " , & that it can correct its flaws and balance itself spontaneously by means of supply & demand in the market.
Ironically during the administation of the Republican President Herbert Hoover the US businesses and owners of vast farmlands were unable pay back the huge debts they had borrowed from banks because of losses they suffered without anticipating them.Thus the banks in the USA found themselves without liquidity & ultimately went bankrupt.That led to a chain reaction which caused the crash of the stockmarket in Wallstreet,New York City,& the bankruptcy of businesses of several sectors of the US economy,notably industry, & agriculture,which,consequently,laid off hundreds of thousands of blue collar & white collar workers who, in their turn, suddenly found themselves unemployed & without regular monthly salaries or wages.Hence the entire US population started feeling the pinch of the Great Depression of 1929-1933 which proved contagious and eventually infected European economies which started suffering from recession, high unemployment and hyper inflation.In such circumstances even huge bundles of paper currency did not suffice to purchase even a good as tiny and cheap as a small box of matches.Paper money became quite worthless.
As a result of high unemployment,hyper inflation, and recession Herbert Hoover lost in the election & was replaced by the Democrat Franklin Roosevelt in the USA while in Germany the Great Depression was one of the main reasons why Adolf Hitler rose to power & became chancellor of Germany in 1933.
Surprisingly & miraculously the Great Depression coincided with the emergence of the most brilliant economist of the 20th century,the english John Maynard Keynes, who came up with the idea of direct government intervention in national economic affairs,in his book " The General Theory", by two means :
1) Government taxation.
Keynes ( his recovery ideas where termed " Keynsian economics ") urged governments to be constantly responsible for keeping the national economy prosperous by spending money (public sector) much more than collecting money (in the form of taxes), thereby bearing a "deficit budget " in order to stimulate the economy in times of recession. And to the opposite,Keynes proposed that governments should collect much money from the people
( private sector) by way of various taxes in times of inflation,thus ultimately winding up with a surplus budget.
In Capitalism, the painful dilemma is termed "Philips Curve" which is the tradeoff between unemployment & inflation. That is to say capitalism should be plagued either by inflation, or unemployment.
When bearing a deficit budget the government usually covers the deficit by resorting to one of those methods:
1)borrowing from the people (private sector) by selling them guaranteed,long-term bonds.
2)borrowing from private banks.
3) borrowing from the Central Bank
( lender of last resort).
4)printing paper money continuously.But this is the worst & most unrecommended method because the abundance of liquidity (cash money) starts chasing the too few goods in the market &,consequently,causes high inflation in a relatively-short period of time...