TJP

The Money Supply Determines Income and Employment

By Byron A. Ellis – October 02, 2009

The average citizen is unaware of the role of money in determining income and employment. The Federal Reserve (Fed), a government agency, uses monetary policy to manipulate the quantity of money, interest rates, and income. Thus, it is vital for Americans to know how monetary policy works, since it has stifled economic growth and employment.

The Fed uses open market operations to increase or decrease the available money in circulation. The Fed is one of, if not, the most powerful government agency and its members are not elected, rather they are appointed.

If the Fed reduces the money supply, the economy contracts, if it increases the money supply, the economy expands. Contractions could cause unemployment and deflation and expansions could cause employment and inflation.

The effect is similar to decreasing or increasing household income. If household income is increased more goods and services are consumed. Conversely, if household income decreases less good and services will e consumed.

Open market operations are government purchases and sales of U.S. Treasury and federal agency securities (bonds). The Fed makes the purchases or sales to change the supply of money and bonds in the economy. For instance, a government purchase of bonds channels money into the economy. Additionally, it reduces the available supply of bonds causing bond prices to increase and yields (interest rate) to decrease.

Lower interest rates tend to increase investment leading to employment, output and income expansion. Furthermore, it is only at low interest rates that the public will hold large portion of their wealth in cash.

If, however, the Fed sells bonds, it reduces the available money in circulation and increases the supply of bonds. Increasing the supply of bonds causes bond prices to fall and their yield (interest rate) to rise. Higher rates of interest reduce investment, output, income and employment.

Thus, the behavior of the Fed affects the nation’s wealth and hence the individual’s.

The Fed failed to increase the money supply between 2003 and the fourth quarter of 2008, mainly because their focus was on price stability through inflation targeting. Thus, it was not focused on expanding the economy and ensuring the availability of jobs.

As a result of the Fed failure to increase the money supply, the demand for real money balances exceeded the real money supply, leading to relatively higher rates of interest and declines in income, output, and employment, as well as an excess supply in the asset market (bonds, residential housing, etc.).

However, in order to deflect blame from a disastrous Fed monetary policy that constrained income and led the country and the world into recession, the blame has been placed on marginal homebuyers.

According to the National Income Products Accounts (NIPA), residential investment is less than 5 percent of the gross domestic product (GDP). It is, therefore, beyond silly to argue that sub prime mortgages to marginal homebuyers triggered the recession. In 2007, only 13.5 percent of U.S. mortgages were sub prime.

Perhaps, it is such misidentification of root causes, or deliberate deception, that has hindered optimal responses to the ongoing economic crisis and slowed the recovery. 

The root cause of the recession was lack of monetary growth coupled with rising energy prices that increased the price level and reduced the real money supply. For instance, when the price of gasoline increased, more nominal money was needed to purchase the same quantity of gasoline purchased before the increase; at $2 dollars per gallon, $100 dollars could purchase 50 gallons. However, at $4 dollars per gallon it would require $200 dollars to purchase the same 50 gallons of gasoline.

Thus, given a rise in the price level of needed commodities, individuals are forced to reallocate limited financial wealth from interest bearing assets, including housing to money. As a result, the demand for real money balances exceeded the amount of real money supplied by the Fed and the supply of real assets exceeded the demand for real assets. And, the first manifestation of excess asset was in residential housing.

The recession could have been prevented if the Fed had increased the money supply in 2006 when the price of energy was peaking; and had the government reduced mortgage interest rates through subsidies.

A reduction in mortgage rates would have prevented many marginal borrowers from defaulting on mortgages and would have provided surplus cash for non-marginal mortgage borrowers. More importantly, by avoiding massive foreclosures, home prices would not have plummeted and loss of wealth would not have been catastrophic.

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