Ben Cerruti
Basic Economics We All Need to Understand
September 7, 2009

Reading what follows may be of help if you are one who would like to have a better understanding of what the recent and future actions of our government may have on our economic future.

Those who took Economics 101 in school may recall the following basic formula:

M x V = P x T = gross income

M = invested money

V = velocity (the number of times this money is turned over per unit time)

P = price

T = number of transactions per unit time

Business people apply this formula regularly whether they know it or not. The more times they can rollover their investment, the more gross income they derive. However, the gross income is also dependent on having an optimum price on a product that will cause an optimum number of transactions to occur. Businesses like a super-market can operate with a small margin of profit because there are a large number of transactions that occur every day. Conversely, a clothing merchant would have to set prices with a higher profit margin because they would not have as many number of transactions to optimize their gross income. This same analogies applies to our government's business.

M x V = P x T = GDP (gross domestic product)

M = money supply

V = velocity (the number of times this money is turned over per unit time)

P = price (reflected by cost of goods/services indices's relating to inflation or deflation)

T = number of transactions for goods and services per unit time

Since the great depression years, circa 1930's, velocity has stayed relatively constant until the present period, except for a slight increase in the 1990's,. The degradation of credit, due to the housing market collapse, caused velocity to decrease markedly. As a result GDP fell accordingly. The FED (Federal Reserve Bank) has attempted to offset this by increasing the money supply. However, in order for an increase in GDP to take place the other side of the equation (P x T) must increase. This requires that the increase in the money supply be used effectively to bring back velocity to what it previously was. Milton Friedman supplied me with graphs to show that there is a two year delay between a change in the money supply and an attendant reaction in GDP. Therefore corrections do not take place instantly.

There are also actions by the legislative and executive branches of government that fiscally address economic problems with various spending programs. The Treasury is called on to fund them by issuing bonds that are purchased by foreign banks and the FED. Thus besides increasing the money supply the government hopes to kick start the economy, increasing P x T and thus GDP. However, unless GDP is increased sufficiently to offset the debt generated by the funding of the spending plus interest, it may very well fail.

In the past it has been the private sector with its inventiveness and private investment capital to nurture it that has been the catalyst for economic growth leading to marked increases in GDP. All one has to do is look at the companies that sprouted up and matured into large enterprises employing thousands of people. Among these many firms the names that come to mind are Hewlett Packard, Intel, Microsoft, Dell, Cisco Systems, Oracle, Yahoo and Google.

It would rationally appear that the government, at some point, should consider incentivizing the private sector. This could be done by harnessing the private sector's ability to leverage capital to create new products, as has been done in the past . The seed capital could be provided by cutting corporate income taxes that are presently the highest in the world and completely eliminating the capital gains tax. Able to keep more of their derived revenue these companies would be able to retain and/or hire new employees and plan for expanding their activity. Without the necessity to plan investments based on the effect of capital gains taxes, investors whether they be stock market types or venture capitalists, would likely be incentivized to buy into the future of American enterprise as has previously occurred.

Of course, when and if the increase in the money supply (M) finally takes hold and velocity (V) accordingly starts to increase, prices (P) will tend to increase creating inflationary pressure. To counteract this the FED will surely start to cut back on the money supply (M), however recall there is a two year delay before changes in the money supply cause a reaction in GDP. As was experienced when the FED last attempted this it caused our present economic crisis. Decreasing the money supply will cause interest rates to increase and our economy will again be entering into what we would hope will only be a recessionary period but could again be more severe and long lasting.