There are headlines making the news about the inflation that’s coming to the US. And that monetary/fiscal policies are out of control and that quantitative easing will deliver a repeat of 2008 financial crisis. I’m going to aim to simplify all these terms in this article and make you understand the reasons behind these actions, their intended purpose and what the future is looking like.
Aggregate Supply | Aggregate Demand
Before we go any further, there’s some economic principles you must understand.
Aggregate means several elements. When we talk about aggregate demand, we are talking about “several elements within the economy that affects expenditure”. These expenditures can come from consumer spending, investments, government spending and net exports.
The following will increase aggregate demand (AD):
- Increase in Consumer & Business confidence
- An increase in House prices & Asset prices
- Government Expenditure
- Foreign money coming in
- Lowering Interest Rates
- Reducing Taxes
All these make sense. Anything that raises the prospect of more money in your pocket will increase AD. But what happens when AD increases suddenly and unexpectedly?
A sudden increase in AD:
- Will increase inflation
- Increase GDP & Employment
This makes sense. Sudden influx of money increases demand for production. But eventually the inflation means too much money chasing too little goods. This increases the price of the same goods you could of bought for less. The increase in inflation;
- Will make people feel poorer which reduces consumption
- Increases interest rates, slowing down investments
- Increase the domestic currency exchange rate relative to other currencies.
All which reduce a nation’s GDP back to where it was. This is the normal cycle of the economy. But it will require government intervention to prevent inflation from continually rising.
GDP is how nations measure their economic output and thus, the size of their economy. In general, the more it grows, the better. There’s exceptions to that. Anyway.
So now you know. If there’s a sudden increase in aggregate demand, it will increase inflation, along with the GDP and employment into a unsustainable boom. Then it corrects itself due to the inflationary pressures with a little help from the government. Any sudden increase in consumption (C), investments (I) or government (G) expenditure, will increase aggregate demand and thus increase inflation. The opposite is also true. Any sudden decrease in C, I or G, will reduce inflation.
Also remember; inflation is good when the economic expands along with it.
Aggregate supply in basic terms means “the elements that make up all the production”.
What affects the aggregate supply curve?
People’s expectation of future inflation. That’s it.
To give an example. If labor unions expect inflation to rise in the near future, they will make arrangements for employees to ask for higher wages. The increase in wages will reduce employer profit margin and so companies raise prices & production. This also increases inflation and it also increases GDP along with it.
any sudden expectation of future inflation, will increase production as a response, which will increase inflation and GDP.
Combined, the aggregate demand and the aggregate supply are responsible for the conditions you feel at home that relate to inflation, unemployment, wage adjustments, tax increases and interest rate hikes. And all this goes up and down all the time. And the governments job is to reduce the variance between the “up and down”, so the people at home don’t feel the severity of the shocks.
But what actually GROWS the economy?
LRAS is what grows the economy. It stands for long-run aggregate supply. The name is not important unless you’re an economist. Just remember LRAS and it will do.
LRAS is increased by four elements;
Here’s how each of these cause an economic uptrend over the long run;
An increase in quantity of land will increase a nation’s ability to produce goods and services and move LRAS to the right on the GDP scale. Throughout modern history, invading other countries to take land has become vastly unpopular. So this is no longer an option. QUALITY of land however is still possible. Increasing quality of land basically means extracting all the useful resources out of the ground; minerals and oil deposits.
An increase in quantity of the labor force or an increase in the quality of it (high productivity), will increase a nation’s ability to produce goods and services. Size can be increased with birth rate and allowing skilled workers to migrate into the country. The quality of labor highly rests upon personality differences and cultural attitudes towards work, industriousness, education and technology.
Physical capital refers to properties (including commercial), factories, facilities, mines, equipment, computer and software. If physical capital is increased in quantity and quality, each member of the workforce will achieve work faster in a given time frame.
The term technology in economics means being able to augment what we discover and apply it to efficiently produce products and services. Discovering resources, systems in labor, and physical capital will help produce things we have not discovered yet.
These four elements are the ONLY elements that propel a nation’s economy forward in the long run. There’s nothing else to it. The four determine the movement of LRAS on the GDP scale. An increase in any of these elements results in an increase in LRAS which will increase GDP – increasing living standards and quality of life.
But increasing GDP does not always increase living standards. For example, if automation and AI replace humans in the labor force, it will increase productivity output but also increase the unemployment rate. And so, the prosperity of a nation will seem ideal from the surface while internal instability of the working class will rise. This will require a structural shift in employment to bring back ordinary levels of unemployment, which basically means up-skilling and educating people on new jobs. But that will be contingent upon people’s ability to learn jobs of higher complexity.
This issue may be addressed by government policies and higher spending in education. But that still assumes that people have the cognitive ability to take in advanced levels of education. And seeing as the best predictors of long term success is IQ and industriousness, the future appears bleak with regards to automation in my opinion.
Anyway back to the topic.
What happens in a Negative Economic Shock?
When there’s a recession (a period of temporary economic decline) that results from a negative shock,
for example, a pandemic,
here’s what happens;
- Business & Consumer confidence drops. The pandemic further (artificially) facilitated this drop with temporary consumer lock downs and business shut downs. Note that this will also reduce aggregate production which would increase prices of goods and thus inflation.
- The drop in confidence directly reduces the aggregate demand. Makes sense; no more spending, no more demand.
- GDP drops by 10% (more or less) and unemployment increases.
- The drop in AD (we now know) will also cause a drop in inflation.
Other matters that happen in the background; employees and unions forget wage increases and focus on retaining their jobs. Employers seek bank overdrafts and other forms of credit to tie themselves over with cash flow. They avoid raising prices to continue stimulating their business operations.
Two things can happen now
- The government can choose to not act. Aka, a no policy response.
- The government can choose to stimulate the economy.
If the government does nothing, here’s what happens;
- Employers continue to cut wages and employees.
- Employees living standards will dramatically decrease
- Unions will go on a strike along with the unemployed
- The government will probably lose in the next election
This is what President Hoover did in the Great Depression of 1930’s. With good intentions, he wanted the economy to ‘correct itself’ without any intervention. It turned out that not acting made the economy far worse than it needed to be.
For starters, inflation does not drop unless monetary policy in some form or another intervenes. But also because humans are not efficient economic machines. We don’t rapidly adjust our lives to accommodate the difficult conditions set forth by economic downturns. We don’t like downgrading our homes, relocating from family and friends, changing jobs on demand, or up-skilling when forced to do so.
Hoover went down as the worst president of United States because of his ‘no policy’ response to the depression.
The second option is for the government to stimulate economic activity. This is done through fiscal and monetary policy; a fancy way of saying –
- Increase government spending
- Reduce taxes
- Reduce interest rates
What happens when these policies fail?
Quantitative Easing Happens
Quantitative easing happens when the Fed or a Central bank decides to purchase government bonds and securities, which are assets on paper that hold some sort of monetary value and generate interest as debt owed. The government in turn receives newly printed cash to stimulate the economy with, while accumulating debt it needs to pay back to the Fed. For more on Quantitative Easing, click here.
The purpose of the new cash is meant to increase money supply and encourage lending. Which in theory, should increase the aggregate demand back to its original position, restore consumer confidence, correct inflation and improve the GDP.
This policy has actually worked effectively in the past. But it seems as though consumer confidence is slow to catch on during a pandemic. The problem with this is that inflation will increase without the economic growth. Quantitative easing is effectively a gamble in a pandemic.
If Quantitative Easing fails, inflation will increase without the economic growth. This is called stagflation. There is speculation that the US might be facing stagflation now.
The challenge to solve stagflation is difficult. Because high inflation is not meant to occur when the economy is weak. We just went through this; a sudden negative shock = a drop in confidence = drop in AD = drop in inflation.
Here is what follows stagflation;
- Higher unemployment
- Potential hyperinflation
- Severe disruption to consumer affordability
What cures stagflation?
Productivity. How do you increase productivity when there’s nothing to be productive for? Two ways;
Infrastructure development or Military warfare.
The problem with developing infrastructure is that it affects the LRAS. Meaning that it will take a long time before the economy responds to the productivity that results from building new infrastructure.
The fastest way to get out of stagflation, and this is something education will not teach you, is to go to war with another country. When AD has dropped compared to prospective supply, military spending will increase capital, labor and immediate effectual use of resources.
It will also open thousands of new businesses across the country; businesses that will seek to provide needs for military personnel, ranging from military equipment, health services, hospitality and the list goes on.
Military victory will also lead to capturing new land through QUALITY; effectively stealing another country’s resources. Read up on US intervention in Iraq 2003, Libya in 2008, and ISIS in 2014. One word; Oil.
When you hear about quantitative easing from now, take a look at inflation relative to economic activity. If the two are not moving in tandem, stagflation is a risk. If stagflation cannot be cured with monetary and fiscal policies, a pretext usually develops to justify war.