Swirling In The Whirlpool!

The term Liquidity Trap was first used in 1936 by Keyenes in his General Theory to describe a  situation where interest rates reach the zero-bound level.  At this point monetary policy has no effect on economic activity.

The concept holds that near zero interest levels there is effective equivalence in the holding of cash with that of government or corporate debt.  With little difference seen between bonds and cash, people will demand cash and continue to put all of their assets in cash as the future is unclear.  Keyenes termed this Liquidity Preference, cash demand therefore is infinite.  Consequences for the economy are that there is little or no capital investment in either machinery or labor which result in one consequence in increasing unemployment.  As cash soars unemployment increases which discourages spending (Aggregate Demand) so money velocity decreases and comes to a halt.  This situation only encourages more saving into cash and a closed loop effect begins (Money Hoarding) which leads to a greater downward spiral in the general economy (Deflation and Depression) once entered, the Liquidity Trap is very difficult to exit.

Suggested solutions in the economic literature suggest fiscal action such as (Q.E.),  the buying of various assets by the Fed or the Government, Bonds, Long Term Corporate or Government is suggested along with Corporate Equities.  Intervention in the Foreign Exchange Markets on a massive scale is also suggested along with Government spending and Tax Cuts as bromides to be considered.

Gasoline War

In looking at the effects of gasoline price increases on the general economy there are several factors at play.

The referenced chart shows dollar expenditure increase at various price levels.  This chart assumes regular grade prices while many new models recommend premium gas to operate their vehicles at peak efficiency, this would skew the numbers even higher.

The effects of gas price increases would be subject to the multiplier.   When considering total economic effects at a multiplier of 3 the net reduction of aggregate purchasing power on items other than gas would be $236.25 per month or $2,835 per year.  It should be remembered that these increased expenditures are on an after tax basis.  That is, you are paying more for gas with money you have already paid Federal Income Tax on, State Income Tax on and Payroll Tax.  In addition you are paying State and Federal Excise Tax on the gas as well as State Sales Tax.  Remember you are paying all these State and Federal additional Taxes on money which you paid Income Tax on already.  Business’s that purchase fuel for their operations have some relief in that they can deduct the cost of fuel from the bottom line “They purchase gas on a Pre Tax basis while consumers purchase it on a After Tax basis.”  A factor to also consider is that a business will pass along to the consumer any additional cost, so it is the individual consumer that pays all these Taxes and increased cost.

One should also recognize that the majority of gasoline sales are on credit cards whose balances are rolled over on a monthly basis with consequent interest charges.  The increased interest expense due to increased gas price would amount to billions of dollars.  This would all be subtracted from aggregate expenditure on other items which would have a negative effect on employment levels.