What really drives our economy?

John Maynard Keynes's ideas on economics have had a profound influence on modern macroeconomics as well as many economic policies of governments.  Macroeconomics looks at the performance, structure, and development of the economy as a whole.  Keynes theory, know as Keynesian economics, states that business cycle fluctuations should be reduced through both fiscal and monetary policy.  If monetary and fiscal policy is what reduces business cycle fluctuations, why doesn't the United States use these policies to end the terrible recession we are currently in? or is the United States already applying them? 

Fiscal Policy

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In a recent article in the Wall Street Journal, Alan S. Blinder discusses our economies current fiscal policy paradox.  

Blinder states, "There are plenty of powerful weapons left in the fiscal-policy arsenal. But Congress is tied up in partisan knots that will probably get worse after the election. On the other hand, the Fed (monetary policy) stands ready -- indeed, seems eager -- to act. But it has already deployed its most powerful weapons, leaving only weak ones. That's the paradox."  

What??  That makes no sense.  Why doesn't Congress want to use fiscal policy?  Ben Bernake (the chairman of the Board of Governors) will have to implement another round of quantitative easing (basically pumping money into the economy) which has already proven not to work.  It's because we live in a world that isn't rational.  If we lived in a rational world, fiscal policy, which packs the power, would be doing the heavy lifting (combining tax cuts and spending today with credible deficit reduction for the future) and monetary policy would take the back seat by keeping interest rates low. 

In my money, banking, and financial markets class, we are currently    studying about the Monetary Policy Framework which includes the following economic goals:  foreign exchange, unemployment, inflation, GDP, banking, credit markets and equity markets.  Like the instrument panel in the cockpit of a plane, these goals are what drive the performance and status of our economy. 

The following is a compilation of my thoughts on the current state of our economy:  (feel free to skim because it's kinda long)

• Gross domestic product (GDP) is the sum of US consumption, investments, government purchases, and net exports.  The two categories of consumption are durable and non-durable.  Durable consumption refers to products (like cars) that are expected to last longer than a year and non-durable are those expected to last less than a year.  During a recession, durable consumption decreases but normally bounces back pretty quickly but not as of recent.  This is a cause of concern for the US economy.

• Investments have decreased significantly during the recession.  Government purchases tend to try to make up for the shortfall of consumption and investment but fiscal policy has been hesitant to get to involved which hasn’t helped the decrease in GDP.  Recently, due to a ailing economy, the US has been importing more than it exports thus causing GDP to continue to struggle.   

• Another source of US economic distress is an increasing percentage of unemployment.  Total unemployment is the sum of frictional and structural unemployment.  Frictional unemployment can be compared to a parking lot.  In order for the parking lot to function, there has to be a natural number or spots available.  Structural unemployment is due to people’s skill sets not matching the skill sets required for available jobs.  In the US, as people are out of a job for a longer period of time, there skill sets begin to rust which leads to permanent unemployment (structural) due to lack of qualification.  This causes the natural rate of unemployment to rise.  Another struggle the US is facing with respect to unemployment is the lack of jobs being created for new entrants (college graduates, etc).  Right now, the combination of not enough jobs being created for new entrants and jobs being taken away for those in the market leads one to believe that the recession we are in is a much larger problem than we might have thought.

• Finally, the US economy is in distress due to a decrease in the rate of inflation.  One reason for the decrease is the increase in productivity. As productivity increases, as mentioned above, the average labor cost decreases which leads to increased profits.  Increased profits cause expected inflation to go down.   It is important that inflation doesn’t increase too quickly but a gradual, sustained growth (2%) is healthy for the economy.  The US isn’t even growing at 2%.

• The decrease in GDP, increased unemployment rate, and lack of inflation are all causes of the economical distress in the US right now.

If you are interested in learning more, Rhett made an excellent post about economics you might enjoy.