TJP

Apparently, the employment mechanism is not very well understood by policy makers. If they understood it, high unemployment would not exist.

Classical economists believed that what is produced is consumed, supply in their view creates its own demand. However, they do not believe that money influences the operation of the economic system.

Nonetheless, an ideally organized economy has to provide enough income to maintain full employment. Hence, the appropriate growth of the money supply matters.

In general, economies are endowed with capital, K, and labor, L, which are at any given point in time available in fixed quantities.

In a closed economy, with two individuals, A and B, producing two commodities, say flour, f, and cars, c; the available capital and labor would be allocated between the production of flour and cars (K = K^f + K^c and L = L^f + L^c). And, the production functions for producing flour {f = f(K^f, L^f)} and cars {c = c(K^c, L^c)} would indicate the maximum output that could be produced from a given combination of capital and labor inputs.

The outputs of flour and cars would be allocated (sold) to individuals A and B (f = f^A + f^B and c = c^A + c^B ). However, an internal shock within the closed economy, such as a natural disaster, could affect the incomes of individuals A and B.

As a result, individuals A and B might not have enough income to purchase all outputs produced in previous period and products would be left in inventory.

Given that not all outputs were sold, producers’ sales expectations for the next production period would have diminished. Thus, producers are likely to use less capital and labor inputs in their production function, leading to less employment.

Clearly, it is the exogenous shock to the economy that destabilized the existing equilibrium.

In an open economy exogenous shocks could occur through natural incidents, wars, increases in energy prices, inappropriate management of the money supply, and so on.

In a monetary economy, such as ours, it is income increases that restore economic equilibrium and effective demand.

How do we increase income?

Some policy makers have argued that fiscal policy, government spending or tax reductions, can be used to prime the economy. However, fiscal policy, whether in the form of government spending or tax decreases, does not expand the money supply, and hence cannot increase income. Income, in general, increases through appropriate expansion of the money supply. Thus, it is appropriate monetary policy that determines the level of employment.

The central bank (Federal Reserve) and banks (the banking system) control monetary policy. The central bank is an independent government agency that uses open market operations to change the stock of high power money. High power money or the monetary base consists of currencies (notes and coins) and banks’ deposits at the Federal Reserve. Banks expand the money supply by providing credit.

In a monetary economy, the availability of credit is a necessary for entrepreneurs, investors, and consumers to execute spending decisions. Bertocco (2005) in “The role of credit in a Keynesian monetary economy” notes that the creation and availability of money influence the level and composition of income.

Banks play a key role in expanding the money supply, and thus far they have been reluctant to do so. Perhaps, they are not expanding the money supply because they understand the nature of the political economy. If they withhold credit, unemployment will remain high and voters will revolt against the Party in power.                      

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