Phillips Curve

Posted by PITHOCRATES - September 17th, 2012

Economics 101

A High Savings Rate provides Abundant Capital for Banks to Loan to Businesses

Time.  It’s what runs our lives.  Well, that, and patience.  Together they run our lives.  For these two things determine the difference between savings.  And consumption.  Whether we have the patience to wait and save our money to buy something in the future.  Like a house.  Or if we are too impatient to wait.  And choose to spend our money now.  On a new car, clothes, jewelry, nice dinners, travel, etc.  Choosing current consumption for pleasure now.  Or choosing savings for pleasure later.

We call this time preference.  And everyone has their own time preference.  Even societies have their own time preferences.  And it’s that time preference that determines the rate of consumption and the rate of savings.  Our parents’ generation had a higher preference to save money.  The current generation has a higher preference for current consumption.  Which is why a lot of the current generation is now living with their parents.  For their parents preference for saving money over consuming money allowed them to buy a house that they own free and clear today.  While having savings to live on during these difficult economic times.  Unlike their children.  Whose consumption of cars, clothes, jewelry, nice dinners, travel, etc., left them with little savings to weather these difficult economic times.  And with a house they no longer can afford to pay the mortgage.

A society’s time preference determines the natural rate of interest.  A higher savings rate provides abundant capital for banks to loan to businesses.  Which lowers the natural rate of interest.  A high rate of consumption results with a lower savings rate.  Providing less capital for banks to loan to businesses.  Which raises the natural interest rate.  High interest rates make it more difficult for businesses to borrow money to expand their business than it is with low interest rates.  Thus higher interest rates reduce the rate of job creation.  Or, restated another way, a low savings rate reduces the rate of job creation.

The Phillips Curve shows the Keynesian Relationship between the Unemployment Rate and the Inflation Rate

Before the era of central banks and fiat money economists understood this relationship between savings and employment very well.  But after the advent of central banking and fiat money economists restated this relationship.  In particular the Keynesian economists.  Who dropped the savings part.  And instead focused only on the relationship between interest rates and employment.  Advising governments in the 20th century that they had the power to control the economy.  If they adopt central banking and fiat money.  For they could print their own money and determine the interest rate.  Making savings a relic of a bygone era.

The theory was that if a high rate of savings lowered interest rates by creating more capital for banks to loan why not lower interest rates further by just printing money and giving it to the banks to loan?  If low interests rates were good lower interest rates must be better.  At least this was Keynesian theory.  And expanding governments everywhere in the 20th century put this theory to the test.  Printing money.  A lot of it.  Based on the belief that if they kept pumping more money into the economy they could stimulate unending economic growth.  Because with a growing amount of money for banks to loan they could keep interest rates low.  Encouraging businesses to keep borrowing money to expand their businesses.  Hire more people to fill newly created jobs.  And expand economic activity.

Economists thought they had found the Holy Grail to ending recessions as we knew them.  Whenever unemployment rose all they had to do was print new money.  For the economic activity businesses created with this new money would create new jobs to replace the jobs lost due to recession.   The Keynesians built on their relationship between interest rates and employment.  And developed a relationship between the expansion of the money supply and employment.  Particularly, the relationship between the inflation rate (the rate at which they expanded the money supply) and the unemployment rate.  What they found was an inverse relationship.  When there was a high unemployment rate there was a low inflation rate.  When there was a low unemployment rate there was a high inflation rate.  They showed this with their Phillips Curve.  That graphed the relationship between the inflation rate (shown rising on the y-axis) and the unemployment rate (shown increasing on the x-axis).  The Phillips Curve was the answer to ending recessions.  For when the unemployment rate went up all the government had to do was create some inflation (i.e., expand the money supply).  And as they increased the inflation rate the unemployment rate would, of course, fall.  Just like the Phillips Curve showed.

The Seventies Inflationary Damage was So Great that neither Technology nor Productivity Gains could Overcome It

But the Phillips Curve blew up in the Keynesians’ faces during the Seventies.  As they tried to reduce the unemployment rate by increasing the inflation rate.  When they did, though, the unemployment did not fall.  But the inflation rate did rise.  In a direct violation of the Phillips Curve.  Which said that was impossible.  To have a high inflation rate AND a high unemployment rate at the same time.  How did this happen?  Because the economic activity they created with their inflationary policies was artificial.  Lowering the interest rate below the natural interest rate encouraged people to borrow money they had no intention of borrowing earlier.  Because they did not see sufficient demand in the market place to expand their businesses to meet.  However, business people are human.  And they can make mistakes.  Such as borrowing money to expand their businesses solely because the money was cheap to borrow.

When you inflate the money supply you depreciate the dollar.  Because there are more dollars in circulation chasing the same amount of goods and services.  And if the money is worth less what does that do to prices?  It increases them.  Because it takes more of the devalued dollars to buy what they once bought.  So you have a general increase of prices that follows any monetary expansion.  Which is what is waiting for those businesses borrowing that new money to expand their businesses.  Typically the capital goods businesses.  Those businesses higher up in the stages of production.  A long way out from retail sales.  Where the people are waiting to buy the new products made from their capital goods.  Which will take a while to filter down to the consumer level.  But by the time they do prices will be rising throughout the economy.  Leaving consumers with less money to spend.  So by the times those new products built from those capital goods reach the retail level there isn’t an increase in consumption to buy them.  Because inflation has by this time raised prices.  Especially gas prices.  So not only are the consumers not buying these new goods they are cutting back from previous purchasing levels.  Leaving all those businesses in the higher stages of production that expanded their businesses (because of the availability of cheap money) with some serious overcapacity.  Forcing them to cut back production and lay off workers.  Often times to a level below that existing before the inflationary monetary expansion intended to decrease the unemployment rate.

Governments have been practicing Keynesian economics throughout the 20th century.  So why did it take until the Seventies for this to happen?  Because in the Seventies they did something that made it very easy to expand the money supply.  President Nixon decoupled the dollar from gold (the Nixon Shock).  Which was the only restraint on the government from expanding the money supply.  Which they did greater during the Seventies than they had at any previous time.  Under the ‘gold standard’ the U.S. had to maintain the value of the dollar by pegging it to gold.  They couldn’t depreciate it much.  Without the ‘gold standard’ they could depreciate it all they wanted to.  So they did. Prior to the Seventies they inflated the money supply by about 5%.  After the Nixon Shock that jumped to about 15-20%.  This was the difference.  The inflationary damage was so bad that no amount of technological advancement or productivity gains could overcome it.  Which exposed the true damage inflationary Keynesian economic policies cause.  As well as discrediting the Phillips Curve.

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