TJP

Expansionary Economic Policies Leads to Adverse Consequences

By Byron A. Ellis

February 08, 2008

Policy makers have determined that monetary and fiscal expansion is needed to avoid an economic downturn. They know from economic theory that expanding the money supply and providing transfers to tax payers increases aggregate demand. However, economic theory, and history, also indicates that such expansionary policies always lead to inflationary pressures, output reduction, and unemployment.

The slowing economy caught the Federal Reserve and the Bush administration off guard. Thus, to provide a short-term remedy, they continue to ignore the adverse influence of rising energy prices. As a result, they prescribed monetization and government transfers to boost aggregate demand.

Artificially boosting aggregate demand does not solve the structural problems plaguing the economy, rising energy prices. In the long run, expansionary policy is likely to compound the economic problem, since the demand for goods and services will increase due to the expansionary policy and the supply of goods and service will decrease due to the raising energy prices.

The result, as depicted in the figure below, will be a temporary increase in output (income) to Y₁, resulting from the increase in demand, and an increase in inflation from P₀ to P₁ followed by a contraction in output, say back to Y₀, resulting from higher energy prices, with inflation rising from P₁ to P₂. Furthermore, as inflation rises, the Fed will increase interest rate and restrict the money supply in an effort to diminish aggregate demand.

Failure of the Feds and the Administration to acknowledge that rising energy prices are the principal reason for the economic slowdown leads to misdiagnosis of the economic problem, and hence incorrect remedies.

The Feds and the administration identified the crisis in the sub-prime market as the reason for the economic slowdown. However, the crisis in the sub-prime market is a symptom of the economic problem; it is not the cause. The reason why potential homeowners cannot pay they mortgages is because rising energy prices reduced their disposable income.

The price of energy doubled since 2003 and it has caused increases in virtually all goods and services. Thus, the mortgage portion of many homeowners income has to be allocated to more expensive food and transportation, reducing their ability to pay their mortgages.

The economy’s structural problems can be corrected by implementing mechanisms that reduces the cost of energy, particularly high oil prices. Thus, stabilizing Iraq and lowering the Iran rhetoric would be helpful.

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