TJP

The Stimulus is Necessary to Create Employment

Byron A. Ellis – February 27, 2009

The Federal Reserve (Fed) is responsible for stabilizing prices, reducing financial and output volatility, and ensuring maximum employment. Thus far, however, monetary policy has not worked. Moreover, lowering interest rate close to zero may have created a "liquidity trap;” a situation in which the public is prepared to hold any amount of money at a given interest rate. Some economists believe that whenever there is a liquidity trap monetary policy implemented through open market operation does not affect interest rate or the level of income.

As a result they argue that given the potential for a liquidity trap, the only other tool available to spur the economy is fiscal policy. Thus, they conclude that a fiscal stimulus is necessary because the existing aggregate demand is insufficient to create needed employment and sustain standards of living. There is, however, an alternative that the Fed can use and that is the real balance effect; if the real stock of existing money balances exceeds the demand for real money balances, the demand for real assets would exceed the supply of real assets. Thus, it appears that the Fed need to expand the stock of money supply, since either a change in the nominal money supply or a change in the nominal price level would impact household wealth and affect consumption and output.

It appears that the Fed has relegated their core mission to the Executive Branch of government. Thus, forcing the government to use fiscal spending to increase aggregate demand. Additionally, they continue to misidentify the root cause of the economic crisis, which is lack of income (wealth). The housing foreclosures and under funded banks  are merely symptoms of lack of income. For instance, if homeowners in foreclosures had sufficient income they would have avoided foreclosure.

Aggregate demand is the total demand for goods and services; it is equal to the level of income (output). Aggregate demand is sum of consumption, private investment, and government spending. When aggregate demand falls, income (output) diminishes and unemployment rises.

When consumption and private investment are diminishing, and monetary policy is ineffective aggregate demand can only increase through government spending. Thus, the Obama administration is doing what the Fed failed to do. However, stimulating the economy through government spending is not the optimal method of expanding economic growth; fiscal policy is a blunt instrument and can lead to protracted inflationary periods and high interest rates. Furthermore, fiscal stimulus could leak out of the economy.

Stimulus leakage would occur if the bulk of the increase in government spending were used to buy foreign goods. For example, increases in crude oil prices due to Middle East instability (Israel attacking Iran, Palestine, or Lebanon) would cause significant income (stimulus) leakage.

Income leakage occurred as a result of the Iraq invasion, which caused crude oil prices to increase significantly. Thus, U.S. income (wealth) was transferred from U.S. consumers and businesses to energy conglomerates and oil producing countries. It is this transfer of wealth that has severely affected aggregate demand: consumption and investment.

Spikes in crude oil prices affect the allocation of consumers’ income and cause the general price level to rise.  Increases in energy cost adversely affect consumers’ overall demand for goods and services; it is akin to a tax on consumers’ income.

The oil supply shock of 1973-1974 and 1979-1980 were followed by worldwide recessions, and the Iraqi invasion of 1990 caused a barrel of crude oil to increase from $21.00 to $40.00, even has Saudi Arabia and other OPEC countries increased production to compensate for Iraqi and Kuwaiti’s supplies. Here too, the price shock was followed by a recession in 1991 and 1992. And, the 2003 invasion of Iraq increased the cost of crude oil significantly and was followed by the 2008 recession.

Increases in crude oil prices redistribute income from consumers to producers; forcing consumers to reallocate their budgetary outlays to cover higher transportation and home heating costs; additionally, higher transportation costs raises the cost of transported goods, such as food, construction materials, and so on. It also affects the business demand for capital equipment.

It is this reallocation of budgetary outlays by consumers and private investors that reduces demand for goods and services, such as housing, entertainment, clothing, food and so on, as well as the demand for capital equipment and employee training.

If consumers and businesses are not demanding goods and services, and the Fed is incapable of stabilizing the economy, the demander of last resort has to be the Federal government.

It is unfortunate that congressional Republicans are so engaged in divisive politics that they’ve lost sight of the greater good: creating employment and raising the standard of living for their constituents. Perhaps, they should focus on the ability or lack thereof of the Fed to effectively manage the economy.

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