Wednesday, December 24, 2008

Quick reminder: GDP and money turnover

Easy for the non-economist to forget. This comes from the Bush I administration ...
Bruce Bartlett - How to Get the Money Moving -

... When everyone in the economy suddenly stops spending, the number of times that money turns over falls. Since the gross domestic product equals the money supply times its rate of turnover — something economists call velocity — this means that if the money supply is unchanged then G.D.P. must fall.

Theoretically, the Federal Reserve can compensate for a decline in velocity by increasing the money supply. But in times like these it is very hard for it to do so because of something economists call a liquidity trap. When this occurs, the Fed cannot inject liquidity into the economy because its normal means of doing so no longer works. In a liquidity trap, trying to expand the money supply is like trying to push on a string.

Normally the Fed expands the money supply by buying Treasury bills and paying for them by creating money out of thin air. When it wants to contract the money supply it does the reverse, putting Treasury bills from its portfolio on the market and drawing money out of the economy when financial institutions pay for them.

But when interest rates on Treasury bills fall to zero this process doesn’t work because money is essentially nothing but a perpetual government bond that pays no interest. If the Fed creates money to buy a Treasury bill that pays zero interest, it accomplishes nothing, economically. All it does is trade one government security for another that is virtually identical. There is no net increase in liquidity.

Under these circumstances, when the normal rules don’t apply, the government must find more creative ways to ease credit conditions and get the economy moving again.

First, it needs to increase the budget deficit. This expands the amount of Treasury bills in circulation and is the same as expanding the money supply, which is necessary to keep G.D.P. from shrinking due to a fall in velocity.

Second, the Fed needs to revise its operating procedures. Instead of buying only T-bills it needs to buy securities with positive interest rates. These include longer-term Treasury bonds and securities issued by government-sponsored enterprises like Fannie Mae. If necessary, the Fed could also buy corporate bonds, state and local government bonds, or even bonds issued by foreign governments.

Third, the government must try to raise velocity by stimulating aggregate spending in the economy. This is harder than it sounds. Buying bonds and securities may expand liquidity, but it doesn’t increase spending. And we know from experience that tax rebates don’t work because people save them...

Sounds Krugmanesque.

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