Our economy is measured by GDP. Gross Domestic Product, which is the total dollar value of all final goods and services sold per year. One approach national accountant’s use is the "expenditure approach" for counting this. Using the expenditure approach there are four variables. Consumption, Gross Investment, Government Purchases and Net Exports (Exports minus Imports). In America about 70% of GDP is Consumption. This is what we spend each year with what we have left over after taxes. Gross Business Investment is about 14%, Government Purchases are about 20% and Net Exports is a negative 4%, meaning we import more than we export.
GDP is about 14 Trillion a year, so Consumption being 70% is about $9.8 Trillion a year. Those policy makers, whose job it is to control inflation /deflation and reduce unemployment use either Fiscal Policy or Monetary Policy to do their job
Those who use Fiscal Policy are members of the Federal Government. They have two options for doing the job. They can raise taxes and reduce government spending to shrink the money supply. Or, they can lower taxes and increase government spending to increase the money supply. The money supply is what we who are part of the 70% consumption group have available to buy goods and services with.
Those who use Monetary Policy are members of the Federal Reserve Banking System Central Bank, a privately owned bank that is regulated by but not under control of the Federal Government. They have three options for doing their job. TO SHRINK THE MONEY SUPPLY....They can raise the reserve rate requirement, they can raise the discount rate/federal fund rate, or they can engage in open market transactions by selling government securities (treasury notes, aka T-notes, T-bonds and T-bills). By reversing their actions on these three options, they will EXPAND THE MONEY SUPPLY.
EXAMPLE: When you deposit $100.00 in your checking account, if the RRR is 10% (reserve rate requirement) this forces the bank to put 10% of your deposit on deposit with the Federal Reserve Central Bank. They are supposed to loan out the other 90%. When they loan out the other $90.00 to one of you, and you deposit that in your bank, your bank must put 10% on deposit with the Central Bank, and then loan out the other $81.00. This is called "fractional banking" and it is how banks create money. If all of you went to get your money out of the bank at the same time, only 10% of you could get all of your money, or all of us could get 10% of our money. The rest of it is imaginary money or electronic money...it does not really exist. (IT's A Wonderful Life....Jimmy Stewart and the Building and Loan)
Point is, the lifeblood of our economy is the money supply. Very narrowly defined as M1, or all the cash, coins and checking accounts available for Consumption! M2 includes M1, plus all short term interest baring accounts which you can get your hands on quickly for Consumption!
The money multiplier is used by banks for creating money in their fractional banking system, (1 divided by the RRR equals the multiplier... or 1 divided by 10% equals 10, ...or for every dollar you deposit in your bank, they can create 10 more by loaning out the other 90%). However, what happens when banks decide it is too risky to make loans and much safer to make money by investing their deposits into the stock market. What happens is inflation in the stock market! Stocks go up in price for reasons other than earnings or performance. Ever since the 700 Billion TARP bale out of banks in 2008, the stock market has been surging. Since then, the Federal Reserve Bank has been putting Billions into the Banking system. 600 Billion Aka QE2 and 85 Billion a month aka QE3.
They have been buying T-Bonds from their member banks in the form of Mortgage Bonds. These are those bundled mortgages which had many foreclosed houses included in them, which put many banks into a state of being insolvent. Not only were banks making mortgage loans which went into default, they were also investing in those bundled mortgage derivatives that went upside down. So, in essence, the Central Bank has been creating new money, that does not really exist anywhere but on paper, or in the computer, to bail out their member banks. This has helped stabilize the housing market, but those deposits in member banks are supposed to trickle down into the economy, expanding the money supply, creating jobs. What it is doing is creating wealth or stabilizing wealth of the homeowner, and driving up prices of stock in the stock market, which also has a wealth effect for those who own stocks. With that wealth, they can afford to CONSUME more.
The challenge with wealth creation of this type is the extreme reduction of the MULTIPLIER effect. When loans are not made with deposits, because banks are sitting on excess reserves (bank reserves minus the RRR), or they are putting excess reserves into the market, there is very little impact for the multiplier. FRED, the Federal Reserve Bank web site http://research.stlouisfed.org/fred2/series/MULT, shows this started in 2008 when TARP was given, and has continued since.
Another multiplier is the Marginal Propensity to Consume each one of us have. We have a propensity to consume and to save. Added together they equal 1. If you earn 1,000 a week with a MPC of 90% then you have a 10% marginal propensity to save and a 90% marginal propensity to spend. Marginal means the next dollar you earn from zero going forward. We typically have a higher MPS as our incomes rise, meaning the more we earn the more we save. However, in this economy, most of us who influence the 70% of GDP number are spending at least 90% of what we earn. This other multiplier is found by dividing 1 by the MPS. In this case 1 divided by 10% equals a multiplier effect of 10.
Finally, when we go to the pump to buy gas or to the store to buy food and the price has gone up by 5%, do we buy less food or less gas? No. Those two items have a demand which is relatively if not perfectly inelastic, meaning we don't respond to a price increase or a price decrease...we generally buy the same amount. For those of us in the 70% consumption bucket of GDP, gasoline makes up about 2.1% of our spending or about $430 Billion a year. When the price at the pump goes down by 10% or about 30 cents a gallon it amounts to an extra $43 Billion a year for us to spend on something else. We will not buy more gasoline, we will buy something else. If we use the multiplier of 10 it means a $430 Billion impact on GDP....meant GDP just grew by 2.1%. Sadly, this multiplier impact works the same way in the opposite direction.
For those who do not know, 2% growth in GDP is the expected hoped for gain this year and each year going forward in these times. The increase in GDP hoped for by the actions of the Central Bank, using the wealth effect, will be wiped out with inflation in gasoline and or food. Food consumption accounts for about 3% of our consumption dollars, so you can see how the anticipated 4% inflation in food prices, with the multiplier impact, will further push us into zero growth in GDP going forward.
Fiscal Policy and Monetary Policy actors, expect us to believe their actions will increase the money supply, consumption, GDP and the job market, as fast as food and fuel inflation are shrinking the money supply, consumption, GDP and the job market. Current monetary easing actions are continuing to shore up balance sheets for member banks, keeping interest rates low and further inflating the stock market.
The coming QE 4 is a green light for OPEC to raise fuel prices, soaking up those new marginal dollars. Global demand for food, "in the know" investors and global weather challenges will continue to drive up commodity prices. Inflation will remain within the 2% range desired by our Central Bank as we see further disinflation and deflation in most segments of our economy, balanced out by significant inflation in fuel and food. The net effect on the money supply and GDP will be shrinkage, further loss of jobs and major growth in transfer payments to sustain those who will move from pulling the cart to riding.
Like Albert Winfield once said to the city banker who purchased the Albert Tilton farm from him. While unloading a truck load of cattle, which included a very large red bull, the banker told him the bull was of the Short Horn breed. A. W. laughed, spit out some tobacco juice and cried out, "If that’s a short horn bull, I'm a naval aviator"!