TJP

We often hear pundits and politicians assert that businesses drive the economy and that they are not investing because proposed regulations cause uncertainty. However, it is not the businesses that drive the economy, rather it is consumers' income (wealth) and taste (preferences) that drive the economy.

Businesses will not provide goods and services if there is no demand. Therefore, consumer demand that drives the economy. The inability to identify root cause often leads to inappropriate solutions. Demand depends on consumer preferences, income and commodity prices.

When entrepreneurs and investors perceive that consumers' income is insufficient, they are reluctant to invest. Both the Bush and the Obama administration have neglected to buttress consumers' income. Consumption is approximately 60 percent of the gross domestic product (GDP), private investment and government spending is about 20 percent, respectively.

The Obama administration, however, has chosen to concentrate on supporting private investment (bank bailouts) and government spending (fiscal stimulus). Investment spending by firms is a linear function of the interest rate. Therefore, under normal economic conditions low interest rate would increase investment. Currently, interest rates are low and investment remains low.

To reduce employment it is necessary to increase aggregate demand. Aggregate demand is the total demand for goods and services produced in the economy. The Federal Reserve (Fed) could stimulate aggregate demand by increasing the monetary base and making it available to the public. The monetary base is currency in circulation plus bank reserves.

The Fed increased bank reserves significantly between September 2008 to December 2008 by over $800 billion dollars. However, the increase in reserves was to cover bad debts of domestic and foreign financial institutions. Thus, the increase in reserves appears to be conditional and are being widely made available for loans. Apparently, the Fed is continuing its inflation targeting policy in the midst of the economic crisis.

Expansionary aggregate demand policies (loaning the reserves to main street) could produce inflation if the economy is experiencing high levels of employment. Inflation is the rate of increase of prices.

Aggregate demand and output diminish when the Fed restricts the growth rate of the real money supply. The real monetary growth rate has been constrained since 2003 until the last quarter of 2008. Thus, under a restrictive monetary growth policy by the Fed, an economic slowdown was inevitable and it was accelerated by high energy prices.

High energy price reduced consumers' real income. For instance, when gasoline price rose from $2 to $4, consumers needed twice as much money than before the increase to purchase the same quantity of gasoline.

Therefore, because the real money supply remained the same or decreased, the demand for money balances exceeded the supply. Accordingly, real financial wealth (W/P) is equal to the demand for real money balances (L) plus the demand for real asset holdings (V) or:

                       W/P = L + V                                                  (1)

And, total real financial wealth is equal to the stock of real money balances (M/P) plus the total supply of real assets (V^S) or:

                      W/P = M/P + V^S                                                            (2)

Substituting (1) into (2) We arrive at:

                      L – M/P = V^S - V                                              (3)

It is clear from equation (3) that if the demand for real money balances exceed the supply (L > M/P) then (V^S - V) is positive, which implies that the supply of real assets (V^S) is greater than the demand for real assets (V). Hence, prices of real assets, such as housing would fall, which is what has occurred during the recession.

If, however, the Fed had increased real money balances (M/P) to be equal or higher than the demand for real money balances (L), the demand for real assets (V) would be equal or greater than the supply of real assets (V^S) and asset prices would remain steady or continue to increase.

Fed policy of inflation targeting  restricts monetary growth. Milton Friedman argued that a steady growth rate of the money supply prevents economic boom and bust cycles. It is time for the Fed to loosen the money supply,  engage in a steady real monetary growth policy, and allow banks to provide credit to the public.

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