Sunday, January 15, 2012

Economics Isn't Rocket Science

Macroeconomics, or the way our economy operates, may be a lot of math, but rocket science it is not.  It actually is one very simple equation.

Income = C + I + G + NX where:

C= Consumption (or personal/individual spending)
I= Investment (or business investment spending)
G= Government spending
NX= Net Exports

Also take into account that when you hear the term GDP or gross domestic product thrown about, they are really talking about income of a nation.  When you have a recession it is a contraction or a period of the overall level of income going down.  When you have an economy that is expanding you have Income or GDP increasing.

During an economic downturn there is a great amount of uncertainty, and business aren't as quick to hire, and may even lay people off.  This causes unemployment to rise, which puts downward pressure on prices.  This increase in unemployment causes consumption (the C in the equation) to fall.

Furthermore, hiring is considered a business investment and in times of great uncertainty business investment goes down.  They put off purchasing new equipment or hiring that new employee, so the I in the equation goes down.

Net exports is the difference between what we export minus what we import and since the United States is a large importer (think of Walmart and others importing massive amounts of consumer goods from China) our NX in the equation is a negative number.

To get to the point, this means that in an economic downturn like the one we just had, where consumer and investment spending are decreasing and net exports are a negative, you see a drop in income, people have less dollars to spend.

To combat this you look to the G in the equation, or government spending.  That is why there was talk of the stimulus plan and shovel ready projects etc.  There was also a push to decrease the value of the dollar relative to other currencies.  This makes United States goods more attractive to export and makes foreign goods less attractive to import.  This policy has led to a lessening in the current account deficit.

We are looking for income for all Americans to increase, and to do that we need consumers to spend and businesses to invest, which you are starting to see happen.  As we continue to get improved job reports, you will see consumers start to spend more.  As consumers start to spend more you see businesses improve their outlooks and start to hire more and invest in new plants and equipment.  This increases tax revenues and helps the government budget.  It puts less pressure on the deficit, and in turn causes there to be less of a need for these stimulus plans.  Government spending works to stimulate the economy and incomes in this way.

Economics is difficult to grasp, and its certainly not a perfect, but it isn't rocket science, and it is the best system devised to date.  It has its flaws, and we need to figure out how to improve the system to make it perfect.  Economies are complex by their very nature, and the more everyone understands the way things work, the quicker we can do away with the uncertainty that comes with the booms and the busts.

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