TJP

Listening to State of the Union speech and the Republican responses of Ryan and Bachmann validates the current state of the nation. President Obama and the Republicans continue to hold opposing views on fiscal policies.

Obama’s view is that government intervention stimulates the economy. The Republicans’ view is that a less active and smaller government stimulates the economy.

According to economic theory, the demand for goods and services depends on income, as well as prices. Thus, it appears that Obama and the Democrats believe that government spending increases income and the Republicans believe that a smaller government and lower tax rates increase income.

Either fiscal policy option could increase personal disposable income and government deficit. However, neither can increase overall income. Only the banking system can facilitate the increase in total income.

When total income remains unchanged, the demand for goods and services decreases. As a result, merchants will sell fewer products and services, which leads to less employment and income.

For instance, at any given time, nations are endowed with a fixed labor force, N; to employ and remunerate the existing labor force require producing and selling certain amount of national output, Y, at a given price, P.

However, if consumers do not have the money, M, to purchase the output produced, inventory accumulation will occur. Therefore, to avoid inventory accumulation the available money in circulation should be equal or greater than the money price of the output produced.

The Federal Reserve (Fed), the banking system and the public determine the money in circulation.

The money in circulation times its rate of turnover (velocity of money), V, should be equal to the price level times the output necessary to achieve full employment.

Some economists, however, believe that money (M) is neutral and increasing it raises the price level (inflation). Others argue that in a credit economy, money is essential for the production process and therefore not neutral.

However, if the banking system (Fed plus banks) removes money (M) from the economy, either the velocity of money (V) would have to increase to maintain equality with the cost of output (PY), or either the price or output, or both, has to decrease to maintain equality with the lower level of money.

If velocity is constant and prices are sticky, as some economists have argued, then when money (M) is removed from the economy or not allowed to grow, output must fall. Conversely, if under the same conditions, money in circulation is added to the economy output should rise.

Money expands when the Fed through Open Market Operations purchases securities from banks and banks use the excess reserves to provide loans. It contracts when they sell securities.

Therefore, in the absence of banks loans to the public, consumer incomes are unlikely to expand and an expeditious economic recovery will be difficult. Thus, unemployment will remain high if credit remains tight.

Neither Obama speech nor the Republican responses to his State of the Union speech articulated a concise mechanism for job creation or for resolving the existing liquidity problems. The arguments were elementary and devoid of any significant content, it was the same old political posturing.

Comment