60 Second Intro

  • Inflation comes from the interaction between Aggregate Demand and Aggregate Supply.
  • A little bit of inflation is often good*.
  • In one model, Aggregate Demand (very similar to GDP) is made up of 4 elements.
  • Those 4 components are : Government Spending, Investment, Consumer Spending and Net Exports.
  • Since government spending plans to deal with the Coronavirus are smaller than the reduction we’re seeing in consumer spending, it seems likely we will see some deflation.
  • If that lasts, the recession we’re expecting could turn in to a depression.

The Australian economy was relatively healthy and enjoyed a small amount of inflation

Inflation is a general increase in prices. It’s usually, on balance, ‘good’* – one of the reasons the RBA has an inflation target of 2-3 percent.

The reason inflation is ‘good’* makes sense if you think about it. If a product is going to cost a bit more this time next week, you’ll buy it now to save money. If it’s going to cost less, you’ll hold off on what you buy. The sum of all those ‘should I use my money’ decisions (or, at least, the ones in which the answer is affirmative) is called Aggregate Demand. I’ve shown the components of Aggregate Demand, below.

For similar reasons deflation is ‘bad’*. If things are going to be cheaper, you’ll be more likely to put off your spending decisions. And then, it’s a bit cheaper and it seems like, if you leave it for a while, it will be cheaper still. So you put off your spending decision. As a result, deflation can be a spiral it’s hard to get out of. Japan just spent about 15 years fighting it and only recently overcame the problem.

The Coronavirus has shrunk Australian GDP. The problem is that the deflationary effect of the reduction we’re going to see in Aggregate Demand could turn a recession in to a depression.

What makes up Aggregate Demand?

In one simple model, the GDP = C + I + G + NX.

One model says GDP is made up from C + I + G + Nx
In one model, Aggregate Demand / GDP is made up from Consumer spending + Investment + Government Spending + Net Exports

That means Gross Domestic Product – pretty much the same thing as Aggregate Demand – is made up of 4 parts : Consumer Consumption + Investment + Government Spending + Net Exports.

3 out of the 4 aspects of that equation (Consumer Spending, Investment and Net Exports) have been reduced by the effects of Coronavirus. As consumers, we’re spending less. Businesses are investing less. As a country, we are selling less overseas because there’s no consumption there either. The only exception is government spending which has increased – in the form of ‘stimulus’ and ‘support’.

When you add up these changes, the difference is concerning.

These are the factors influencing Aggregate Demand in one model.
These are the factors influencing Aggregate Demand in one model.

Adding up the differences in Aggregate Demand

Even with spending an extra 20% of GDP in stimulus, the Australian economy will still see a substantial reduction in Aggregate Demand.
The Australian Government has added to Aggregate Demand with Stimulous / Safety Net payments equal to about 20% of GDP. Aggregate demand overall still falls.

 

To demonstrate the point I am trying to make, in this example, I’ve set G = 25%, I = 10%, Nx = 10% and C = 55% as a starting point for the Australian economy.
In this example, I’ve set Government Spending to 25%, Investment and Net Exports to 10% each and Consumption to 55%. Some of those are based on sourced actuals, some aren’t.

As of early April, according to the ABC, the Australian Government has raised their spending by about 3.3% this year and will raise it by about 6% next year.

Consumption, the main driver of the economy has fallen to very low levels. People aren’t eating out or buying fuel or going to the cinema. They’re not engaging in any ‘discretionary spending’. Businesses are holding off on investment to see what happens to demand. There’s no point building a new cinema if you’re not sure people are going to watch films. Exports are down because the rest of the world is doing the same as we are – hunkering down. Government spending is up – but it’s up by 6% of GDP which isn’t enough to fill the hole.

As a result, net Aggregate Demand has fallen precipitously as you can see from the histogram above.

How we move from a reduction in Aggregate Demand to a depression

What could turn the imminent recession in to a depression is deflation.

There are a couple of ways we could end up with deflation A reduction in Aggregate Demand can cause deflation. A reduction in the cost of production, can cause the same thing. When that happens across the economy, (i.e. in aggregate) it’s deflation.

The Coronavirus is more likely to cause deflation with a reduction in Aggregate Demand – as we’ve seen.

We will have to pay the piper

The WTO (World Trade Organization says there might be a 32% decline in global trade. The fuel line has been cut they say by which I suspect they mean consumer spending has fallen. It is possible that consumers could be much more wary of discretionary spending for years. And if they’re not spending, businesses could hold off on investment.

Government spending to fix all of this is far from over yet. To get Business Investment and Consumer Spending firing again, the government will have to spend more – potentially handing out helicopter money so consumers spend and businesses invest to provide what they want.

I suspect that at that time, there will be a lot of talk about money spent to ‘prime the pump.’ (An economic concept invented by Donald Trump, you might remember!) That too is going to be expensive.

And remember, all the money the government has spent will have to be paid back. That will drop the ‘Government Spending’ element of Aggregate Demand for many years in the future. The Financial Times reported this week in the UK that the British government has already spent what they saved over the last decade of austerity measures in public spending. The UK didn’t like 10 years of austerity and neither will Australia.

I can’t see an outcome other than the government having to totally revise the tax and Social Services system. They’ve already done a number of studies which have outlined the substantial changes that are required to the current system. It seems likely that this crisis will give them the mandate to actually get around to it.

Even after we’ve dealt with the more immediate health effects of the Coronavirus, Aggregate Demand decreases could well lead to deflation and a spiraling down which will be hard to overcome given the tools at hand.

*I am calling these things ‘good’ and ‘bad’ because they have different effects on different people. Inflation advantages borrowers and disadvantages savers, for example, so whether it’s good or bad for you will depend on whether you have a mortgage or a high interest savings account. Phone plans have been subject to deflation in the pricing of data which I suspect you like.