Basic Economic Theory Moment
The Business Cycle
I was on a roller coaster at Great America in St. Louis once. At the
top, we began to drop hundreds of feet and one thousand miles an
hour (well, it felt like a thousand). My glasses flew off, and I yelled,
“Stop the Coaster!” A lot of good that did!
The economic roller coaster is a bit different. It’s true that if the
government does not interfere with the economic business cycle roller
coaster, it will go through ups (inflation), downs (Depression), and all
stages in between the peaks (Hyperinflation) and Troughs (Depression).
The complete cycle averages eight point four years without
government action.
Adam Smith describes the concept in his book The Wealth of
Nations in 1776 and says there should be as little government as
possible (Laissez Faire).
John Maynard Keynes, the father of modern economics, points out the government should adjust the coaster with off ramps using monetary (interest rates, money supply) and fiscal policy (taxation, government spending).
A depression occurs when unemployment rises above ten percent, you have high underemployment (people in jobs with much higher skill
levels than required, e.g., Aeronautical engineer driving an Uber), and
prices are falling. The remedy is lowering interest rates, increasing the
money supply, reducing taxes, and increasing government spending.
Interest rates during the pandemic were near zero, and the money
supply was significantly increased.
Creeping inflation is the stage we all want to stay in. Prices are
rising from zero to six percent, we are near full employment, and
business activity (GNP) is increasing. The Fed currently sets the target
price level at two percent. The current consumer price index is a little
over four.
“Nearly all FOMC participants expect that it will be appropriate to raise interest rates somewhat further by the end of the year,” Powell said in early July before the House Financial Services Committee.”
Hyperinflation is defined as prices rising over ten percent, near full
employment, and the price system is beginning to lose the rationing
function. In January 2021, the inflation rate was one point four
percent, and the Fed lowered the interest rate to near zero. In June
2022, the rate of inflation was nine-point seven percent.
Last week, the Federal Open Market Committee left its benchmark lending rate unchanged at 5% to 5.25%, following a series of rate increases, but raised the median rate outlook for 2023 through 2025.
As you can see, the Fed was worried about hyperinflation and
increased the rate dramatically in June 2022. Hence, your credit cards,
housing, food, cars, and everything else costs you more.
A recession is defined as falling prices, rising unemployment, and
two quarters of falling Gross National Product.
A stage we hardly ever see is Stagflation, which is the worst of all
the worlds. It is defined as raising prices, high employment, and high
underemployment.
Today, the Fed is trying to achieve a “Soft landing.” They want to
prevent hyperinflation and avoid or shorten a recession. So far, they
have done a great job preventing a significant downturn and ramping
down inflation.
In memo two next week, I’ll show you how the Fed controls a
bank, how they increase the money supply, and how it impacts you.
Uh oh, five hundred and fifty-eight words. The End.