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The Fed Lauded and Rewarded for Crashing the Economy

By Byron A. Ellis – September 04, 2009

Aggregate demand is the total demand for goods and services produced in the economy. In order to maintain a growing economy or reduce unemployment, aggregate demand must increase. Policy makers can affect the aggregate demand through monetary and fiscal policies. The Federal Reserve (the Fed) controls monetary policy and the executive branch usually initiate fiscal policy, but it is under the control of Congress.

The instruments of monetary policy are control over the banking system, changes in the money stock and in the interest rates. Instruments of fiscal policies are tax rates changes and government spending. Both policies, monetary and fiscal, affect the economy through changes in aggregate demand.

However, the effects of either policy, in terms of timing and demand, are not fully predictable. Nonetheless, if the Fed increases the money supply the level of demand and employment is likely to increase. Conversely, if the Fed decreases the money supply or maintains a flat rate of monetary growth, the level of demand and employment will eventually decrease.

Since 2005 the Fed policy was flat monetary growth. Therefore, such a policy is a key contributor to the current diminished demand and high levels of unemployment. In a nut shell the Fed policy contributed to the recession.

Imagine the country or the world, for that matter, as a growing household whose income has been flat for four consecutive years. Say, the household membership grew by one member every year during the four-year period. Therefore, given its flat income, it would not be able to increase its level of demand, except if it borrows to augment its income. Moreover, if the price of goods and services were increasing, the amount of goods and services that the growing household could purchase with flat income would diminish over time. Thus, forcing the household to reduce its level of demand.

As the level of demand diminishes, business inventory accumulation increases leading to layoffs, which further reduces consumer demand. As this phenomenon affects more and more households, aggregate demand slowly diminishes.

It is clear from the above example that it is lack of income that causes recessions. And, lack of income results from poor management of the money supply. The Fed is the only authority in the United States that manages of the money supply.

However, policy makers and the news media have deflected blame from the Fed to sub-prime borrowers, even though yearly investment in housing market is less that five percent of the gross domestic product (GDP). And, like poorly managed banks, the central bank (the Fed) has been lauded and rewarded for its poor performance, while middle class Americans are holding upside down mortgages due to Fed induced deflation.

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