Macro Policy and Aggregate demand

People have asked me what the impact if the debt ceiling result will do to the economy. I thought I ought to share this with all of you, since we have not covered any macro economics in this course.

Basically the level of performance of the economy (GDP, Employment, Inflation, Interest rates) depends primarily on what is called the level of aggregate demand in the economy and the money supply (which is manipulated by the Federal Reserve and Treasury. I want to have you think about aggregate demand– the demand for all our goods and services produced in the country, summed up:

Agg Demand =     Consumption spending –demand for our goods by our residents,

+   Investment spending—demand for goods by businesses as capital investment (eg

not spending by businesses to create the consumer goods)

+ government spending— purchases of goods and services including SS, Medicare, Military

+ demand for our exports— demand for our goods by foreigners

Fueling this overall demand for goods and services is the derivative demand for labor, or what in the aggregate is the employment level.

Simplifying, the short term impact of the agreement on the economy last week is largely going to be through the government budget cut provisions, which were pushed by the republicans as a condition for approving the higher debt ceiling. Cuts of a trillion or more $ in government programs (reductions in government spending) are going to cut aggregate demand, and employment levels. The overall reductions in aggregate demand and in employment levels come in two ways: (1) less government spending—in the form of direct budget reductions and layoffs from the government programs and contractors to those programs, and (2) by the fact that laid off workers and vendors will, in turn, spend less (because they have less income), and this will, in turn, create less income for retailers and others (where their spending would have occurred). These businesses will , in turn, lay off workers, buy less manufactured products and make fewer investments. This cycle of contraction, stemming from the large cut in government spending will reduce employment and incomes and spending. Economists believe that a $1 cut in a component of aggregate demand will result in about a $3 reduction in aggregate demand, other things the same. This is called the multiplier. This is Keynesian economics. It provides the basis for thinking of an active role of government in stabilizing the economy (if private demand is weak, then the government can increase spending, and stimulate the economy).

So, my basic view is that the reduction in government program spending (the policy set in motion last week) is exactly the wrong thing to do to our weak economy. It cuts demand for products and services, and will sharply reduce employment. It will create a recession (reduction in GDP), if we weren’t in one already.

Other kinds of policies that would act to weaken aggregate demand would be (1) increasing taxes—which would disposable incomes and reduce consumer spending, (2) anything that reduces confidence in the future economy (which will reduce business investment and consumer spending too, (3) anything that increases the exchange rate or value of the $ vis international currencies—which will mean that US goods will become more expensive to foreigners and foreign goods will become cheaper substitutes for Americans—both of these things will adversely effect aggregate demand.

This is my view, and I am sure other economists would disagree.

Of course, the long term effects of reducing debt will be good, other things the same. Now the government spends about ¼ ( I think) of its budget on interest payments on the debt. This spending doesn’t create many jobs or multiplier effects, and in fact tends to make the government compete with private firms for investment dollars, driving interest rates up, and cutting the job creating effects of private investment.

The psychological effects of the last three weeks or so are probably as important as the budget cuts themselves in terms of their contribution to the level of aggregate demand (and derivative employment). Why factors drive consumers to buy that new car now, rather than wait, or what drives businesses to decide to pull the trigger on the aggressive business plan they’ve been discussing, or to borrow heavily to purchase a new manufacturing facility? Its all about psychology. Psychology drives aggregate demand, at least the first two components: consumer spending and business investment spending. To the extent people or businesses are pessimistic, they’ll not spend if they don’t have to. This fresh pessimism will be felt as a reduction in the level of aggregate demand, reducing spending, incomes, jobs and the cycle of the multiplier. So, the government ends up having two jobs to promote a good economy: (1) to do sensible things to manage the level of their own spending, which is a component of aggregate demand, and (2) to be a cheerleader for optimism. Hard job even without the political overlay. Obviously, the last few days shows us that the investor community is troubled by the prospect of this government to capably steer the economy.