Managing the Economy — Why it is so challenging?
Will take the help of a simple mathematical model to understand the problem
Simple Economic System
The mathematical model of a simple economic system is embedded in the picture below. Note — this is far more complex, it has been deliberately simplified for the sake of understanding.
Note, this is a closed-loop control system and for its output (demand, supply of goods, and services) to remain stable, the transfer function G/(1+GH) has to either remain constant or grow at an optimal rate to prevent the output to get into a mode of oscillation. The other words, the output should be range bound and neither drop nor surge beyond a reference — needed to keep the economy healthy.
Impact of Covid
Due to Covid, the transfer function of the overall economic system changed. This means the Forward Gain “G” and Reverse Gain “H”, got adjusted to some new reference levels “G1” and “H1”. This means the output of the economic system C(s), is no longer the same as it was initially. It has got altered to a new value C1(s) < C(s), as described in the following equation.
C1(s) = G1/(1+G1xH1) x R(s); => C1(s) < C(s); Why? As the transfer function has changed due to Covid impacting the economy.
Impact of Quantitative Easing
The following mathematical model explains the impact of quantitative easing —which is nothing but printing loads of new currency out of thin air. In other words, borrowing from the future.
The whole idea of QE was to nullify the short-term adverse impact of Covid on the economy — so that the output and the demand for goods and services stay healthy and the public remains protected from the harmful effects of Covid.
But the mid-term of QE was severe and bad. Why?
a) C’(s) overshot from its original position by a significant magnitude.
b) Rise in the supply of Cash raised S&P 500 to an abnormal level.
c) Rise in demand (after Covid restrictions were removed) led to an increased level of inflation.
Impact of FED’s Balancing Act
Now FED’s control is anchored around the need to contain the increased demand (trigged by its own actions, i.e QE) by restricting liquidity and the supply of money. It did so by — a) Pulling back liquidity; b) Increasing short-term interest rates, which drives demand down by making credit costly. Let’s assume both these factors together are acting in the opposite direction but with a phase lag of time “t”. The mathematical model describing the system is embedded below.
Note the new term which gets inserted into the equation to control the ill effects of QE and for restoring the balance back to the original state. This term is negative and we hope that it will cancel out the QE term introduced by the FED in the first place (to control the ill effects of covid). But there is a huge problem. What? Note the exponential term attached to Y(s) is raised to the negative power “ts”. The constant “t” measures the “time delay” of FED action to contain the ill effect of QE.
The larger this value (“t”), the lower it will drive the overall term — G1/(1+G1xH1) x exp(-ts). Why? Due to smaller value of the sub-term “exp(-ts)”, and therefore diluting the impact of the FED action in containing and balancing the system.
Key Take Away
There is no doubt that the impact of Covid on the economy would have been less severe in the mid and long-term if the FED did not print such a disproportionate amount of currency (> 5 Trillion USD) to provide relief to the citizen impacted by the lockdown. But the impact on the system has been more severe due to the delay in taking the countermeasures (increasing rates and containing liquidity). As we saw in the model — the greater the magnitude of the “delay” the lower the impact of these countermeasures. Also, the Russia — Ukraine war has added further spin to this complexity. Had the FED acted on time then probably there was a better chance of containing the rising inflation on time. Maybe in such a situation, the need to increase rates would have been less severe than what will be needed now. Also, the spillover impact on the global economy would have been less — the flow of the dollar would have been contained and so would the fall in currencies around the globe, and their imported inflation. Putting it in a nutshell:-
A large proportion of the economic problems that we see around the world is not directly linked to Covid, but due to the actions/inactions of our central banks to contain the problem.
(Views expressed are my own and do not reflect that of my employer)
PS: Find the list of other relevant articles in the embedded link.
