For starters, this debt comes from the United States raising capital through the sales of marketable and non-marketable securities. Marketable securities are the most liquid securities held by the United States. Non-marketable securities on the other hand are the least liquid securities held by the United States. We hold much more marketable securities than non-marketable ones. Below is a list of marketable and non-marketable securities.

Marketable Securities:

Treasury Bills- Short term government securities with a maturity date ranging from a few days up to 52 weeks. These securities are sold at a discount from its face value.

Treasury Notes- Securities that have a maturity date of 2, 3, 5, 7 or 10 years. These securities pay interest every six months.

TIPS- Securities that have maturities of 5, 10 or 30 years. These securities have principles that adjust accordingly to changes in CPI and they pay interest every six months.

Treasury Bonds- Securities that mature in 30 years. These securities also pay interest every six months.

Non-Marketable Securities:

I Savings Bonds- Securities that can be purchased at any time and interest is accrued and redeemed after maturity. This security cannot be redeemed until after twelve months with a penalty of three months interest. There is no penalty after five years. Can be held up to 30 years.

E Savings Bonds- Securities that can also be purchased at anytime and interest is accrued and redeemed after maturity. It also cannot be redeemed until after twelve months with a penalty of three months interest. There is no penalty after five years. Can be held up to 30 years.

Intragovernmental Holdings- Money borrowed from government trust funds such as Social Security and Medicare.

State and Local Government Securities- These Securities are U.S. Treasury Securities that are issued to State Governments to meet their needs as State issued securities become redeemed. State and Local Government Securities consist of Demand Deposits and Time Deposits. Both earn interest, it is typically lower than the  Marketable Treasury Securities listed above. The difference is Demand Deposits can be redeemed as needed but interest is accrued by day and Time Deposits have a maturity of 15 days up to 40 years.

The U.S. government’s debt consists of various types of debt, similar to the debt that is held by a business. To be more specific, the debt held by the U.S. government can be compared to the liabilities section of a business’s balance sheet. With that being said, bonds, as well as other forms oh securities are liabilities held by the U.S. As a result, because bond prices fluctuate as projected income (and ultimately interest rates) go up and down, the total liabilities (or debt) also fluctuates. For this reason on the morning of May 16th, the U.S. did indeed reach the debt limit. Nonetheless, by the afternoon of May 16th, when the trading floors closed, the liabilities held by the U.S. had gone down because the value of the U.S. securities had gone down. This has been the case since May 16th and when you consider this, it is clear that the U.S. government is not lying.

Some may now ask, “then why can’t we count on the bond prices to keep going down? Wouldn’t that help lower the debt?” The answer is– there is debt that must be paid off by August 2nd 2011. Unless U.S. securities become of no value, the U.S. will still have to pay something. However, even though securities with no value soumd like a good thing now, it certainly is not some thing we want.

Should the U.S. default on these debts the value of U.S. securities, such as bonds, will decrease due to the lack of demand. Afterall, if the U.S. fails to pay back the money it owes on some securities, it is likely that they could do so once again. For this reason individuals and businesses will no longer regard U.S. securities as “safe”. Those who currently hold such securities or intended on investing in them may not any more. This will cause the value of U.S. securities in general to decrease. With this, more and more people will dump the U.S. securities that they own to prevent losses to their investments. This will then cause the U.S. to have even less cash on hand as it has to pay back security holders their money. Moreover, it becomes harder and harder to borrow for the U.S, thus increasing the chances of more debt defaults in the future. In conclusion, the only answer at this point is to raise the debt limit and continue to borrow prudently.

Over the last three years, starting in 2007, we saw the economy fall deeper and deeper into a recession. Since 2007, it has been estimated that over 7 million people lost their jobs, and unemployment is currently at 9.7% for the month of January 2010. Since 2007 the Dow Jones, one of the most watched stock indices, had dropped from it’s 14,000 level in October 2007 to a 10,000 level in February 2010. Mean While the S&P 500 has gone from a 1,500 level in 2007 to an 1,100 level today. Over the last three years, The Federal Reserve Bank of the United States have decreased interest rates gradually, to the point that it was at 0.11% in the month of January 2010. In addition, the Federal Reserve have created various programs to create liquidity in the markets, as discussed in part one.

Why has things just worsen over the last three years? Our current economic situation can be described as a liquidity trap. This is a phrase coined by Keynesian economic belief in the idea that government intervention through the use of monetary policy, in times of economic down turn, could prevent increases in unemployment and decreases in output. A liquidity trap, according to Keynesian economics, is the government’s inability to easily stimulate the economy using monetary policy. The main tool of monetary policy is interest rates. When interest rates are high, savings is encouraged and borrowing is discouraged. When interest rates are low, savings is discouraged and borrowing is encouraged. When an economy is in a liquidity trap, the economy is non-responsive to these adjustments in interest rates. In simple terms, a liquidity trap is the exception to the Keynesian view because lower interest rates fails to effect how much savers save and how banks make loans because they do not have the funds readily available to do so.

Before the the largest economies in the world began slumping into a recession in 2007, one of the most recent well known examples of a liquidity trap was that of Japan in the 1990′s. In 1999, short term interest rates in Japan were set at 0.10% — almost zero. At such low interest rate, individuals were reluctant to deposit savings, and banks were reluctant to loan money as a result. Like in the U.S. during the 1930′s, Japan’s stock prices and land prices fell dramatically starting in the 1990′s. This occurred after Japan experienced 8.2% growth each year from 1948 to 1972 (keep in mind average increase is 2%, so Japan’s growth over that time period is regarded as a record breaking rate). Like in the U.S. in the 1930′s, unfortunately, Japan was very focused on maintaining a balanced budget. With that being said, the Japanese government did not do all that they could do to pull the country out of the slump. The unemployment rate in Japan rose to over 8% by 2001, up from 2.1% in 1991. By 2005, the unemployment rate in Japan fell to 4.5%, the best seen so far for Japan.

Some have argued that Japan could have recovered sooner from it’s economic downturn in the 1990′s if it’s government had expanded the money supply, rather than just depend on low interest rates. The same has also been argued for the case of The Great Depression in the U.S. during the 1930′s. I am one that advocates the same for our current economic situation. While it is not fiscally responsible for an individual to spend more that they earn, the same cannot be said about the Federal Government of the U.S. This is because when the government decides to spend more money, it is creating more money and as the amount of money in circulation increases, the value of each dollar that is held or owed goes down due to inflation. As a result of this, the Federal Government is able to basically inflate it’s debt away!

Here’s a simple example to explain. If I owe you $1 today for a candy bar, and the value of a dollar is inflated 50% by tomorrow, that means we have 50% more dollars in circulation tomorrow than we did today. With more money in circulation, the price we are willing to pay for something will go up, so that $1 candy bar has most likely doubled in value by tomorrow. Now by tomorrow, that candy bar is valued at $1.50. However, I owe you $1 from today and I don’t care what the value is today, so I will only pay you what I owe you– $1! That is how the Federal Government can inflate their debt away. When you think about it, If I were the U.S. government and I was only paying you $1 instead of $1.50, you can actually say that I earned a revenue because I am not really paying you all that I owe in consideration to inflation. The name for this act of a government raising revenue from printing more money is called seigniorage.

I conclude this two part post with a summary of my policy recommendation for saving the U.S. economy: The government must spend more to stimulate the economy, and Americans must take this as a chance to spend more, but also save more.

One of the major concerns of some economists is the level of savings within a country. Usually countries with lower levels of savings have lower levels of productivity. Low levels of productivity have a root in investment in capital– when investment in capital is low, productivity is low. When we talk about capital, we are not just talking about heavy machinery, buildings, and tools. We are also talking about education, technology, and research and development that contribute to both education and technology.

Hold on a minute, you might be saying just about now. How does spending less cause more productivity? Well, savings is the source for investments in many cases. This is true because many businesses and individuals do not have the money needed to preform at their fullest potential. That is where banks come in. Banks allow those who have extra money on hand to deposit their money for a chance to earn a return. Banks then redistribute this money in the form of loans to those who need it at a cost. The cost would is the interest rate. When there is a low level of savings there is limited funds for banks to loan to those who need it, hence banks will make less loans. If less loans are not made, the cost of a loan is much higher.

This correlation between savings, investments and productivity can be seen today. Many banks that had made risky mortgages ended up facing defaults. These defaults then reduced the cash on hand held by these banks– they lost their depositors savings (remember these banks were able to make the risky mortgages loans because of the savings deposits that they received; read more here). Now, as you might have guessed, these banks have very little cash on hand. With such little cash on hand, they really can’t make loans as they use to due to the required reserve ratio (the amount of cash that a bank is required to hold under our central banking system).

What would then happen if people don’t choose to save, you might wonder. Wouldn’t we just be better off if consumers just consumed with all of their money on goods and services now? Wouldn’t increased spending create more jobs now, after all, that is what the media believes? That is true, but it’s not the whole story. Increased spending will only help in the short run. However, in the long run productivity may worsen because of the lack of availability of credit due to diminishing saving levels. In other words, because banks cannot make as many loans, there will be lessening investments made in technological advances, education, and machinery, all of which would have otherwise increased productivity.

This role of savings is stressed in the well known Solow growth model, which states that maximum productivity is reached when we have the right amount of investment in capital. This right amount of investment in capital should also make up for loses in productivity due to depreciation. The name that we use for this right amount of capital is steady state level of capital. At the steady state level, we produce the most output. Keep in mind this interprets into the most possible income, and this means more people are employed, and those who are already employed may be seeing an increase in their income. For this reason, I strongly believe that investment in capital is needed to save the economy.

In that case, looking for instant increase in consumer confidence when it comes to spending habits after a year of attempted recovery from a recession by the Federal Government makes no sense. We should also be looking increases in savings and investments, because it is something that is needed in order to have a healthy and long lasting recovery. Like I said before, there is limited liquidity in the markets, and we will have to get rid of that problem in order to make room for increased consumer confidence, increased spending and investments, etc.

While the purpose of the Stimulus Package was to increase the marginal propensity to consume so that more people will be employed again, it’s not the only issue that the general public faces. Many have also lost their savings, as I stated earlier, and it is reasonable to believe that they will try to recoup as much as they can in the coming years. To our luck, it does seem that this is happening right now. Now we just have to accept the fact that the market is correcting itself in this sense, and there is little that we can do. Moreover, there is little that we should do.

(to be continued…)

Only time will tell how telling such beliefs are. Myself being one that disagrees with these foretellings, I have a different prediction. I believe that people are confusing this certain interest that economists have in the Great Depression today to be something bad. Yes, it is true that economists have shown a great interest in studying the depression recently, but that does not mean what we are experiencing now is anything like the Great Depression. The study of the Great Depression is nothing more than a guide for policymakers to make sure that history does not repeat itself.

What happened during the depression of the 1930′s can be explained by the debt-deflation theory. This theory describes the effects of an unexpected fall in prices due to a decrease in the availability of credit, assuming that most demand prior to that point was created by debt. With this reduction in demand, there was less products and services being purchased, and businesses required less being produced. With this, less people were employed, and even less demand was the result of it, production was cut back by even more, more jobs were lost, and this cycle continued. This sounds like what is happening today, however it just isn’t. The depths of the Great Depression has it’s roots in how the Federal Government and Central Bank chose to react to it.

There are a couple of mistakes made in the 1930′s which helped further the depression. One of these mistakes was that of the Federal Reserve Bank allowing the money supply to fall by 25% from 1929 to 1930, then also allowing the money supply to decline even further each year following that. This continued decline in the money supply was the result of numerous bank failures. Banks during that time were allowed to fail, which in turn worsened the already falling consumption and investment rates (keep in mind that banks have the role of providing funds to those that need it when they need it). As a result, businesses and individuals in need of funds at the time had no access to it.

The Federal Government was also to blame, as they tried their best to maintain a balance budget, rather than save the economy. Though there were a number of programs that went into effect during the Great Depression to help relieve Americans of their struggles, such as The Federal Home Loan Act and The Emergency Relief Construction Act, this was accompanied by tax increases. The Revenue Act increased taxes on mostly lower and middle income consumers starting in 1932.  Meanwhile the unemployment rate had just reached 24% that same year. To further the difficulty in which the country was facing at the time, there were also attempts to create a closed economy. The Smoot-Hawley Tariff Act was one of the policies implemented, raising tariffs on thousands of imported items.

Today things are definitely different. When our major banks began to face insolvency in 2007, the government did not ignore it. These financial institutions were saved by the well known $800 billion bailout. Though too many people view the bailout as unjust, these very institutions today are providing liquidity to our economy to get it going again. The government had also taken it upon themselves to consider the needs of it’s citizens facing unemployment and smaller incomes with the $787 billion Stimulus Package that addresses everything from tax cuts to job creation. If you would like to track government spending as far as the Stimulus Package goes, you may visit www.recovery.gov . Based on this web site, the Stimulus Package has helped make the following possible:

• 640,329 jobs have been created
• $288 billion will be going to tax cuts, of which $92.8 billion has already been spent
• $275 billion will be going to contracts, grants and loans, of which $69.6 billion has already been spent
• $224 billion will be going to entitlements, of which $97.5 billion has already been spent

When it comes to the U.S. interaction with other countries, we have not resorted to  a closed economy. Due to this, the U.S. is actually seeing a large amount of foreign dollars pouring into the economy. Recent reports released for November 2009 by the Buearu of Economic Analysis show U.S. exports totaling $263.9 billion, up from October 2009′s $246.1 billion (see full report here– keep in mind we’re looking at the short term difference; the change in exports during 2009 to examine the economy’s response to the government’s response).Foreign investments in the U.S. has also become very common, and continues to be despite the economic downturn, such as the debatable sovereign wealth funds .

To add to this, the Federal Reserve Bank has kept a close eye on the money supply. So much so that they have not hesitated to open their discount window to financial institutions in need starting in 2007. In addition, they have even created new bodies to provide more liquidity to the institutions that need it in the coming days (note that  this is possible due to the dollar becoming a floating currency; one that is not backed by commodity, unlike in 1929 when the dollar was backed by the gold standard and the money supply was limited). These newly created bodies include the following (click on the bullet points for a full description):

• Term Auction Facility
• Term Security Lending Facility
• Primary Dealer Credit Facility
• Interest on Reserves
• Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility
• Commercial Paper Funding Facility
• Money Market Investor Funding Facility

It is true that the cost of living is going up, which include increases in State taxes. Some may argue that these rises in the cost of living will make the increase in government spending meager. So the question now is, will the rising cost of living counteract the efforts of the Government and the Central Bank to prevent another depression? This is something I will talk more about in the next post.

Now that we all can acknowledge that the Obama Stimulus Package was indeed a good thing, even though it does bare some risk of unfavorable outcomes, let take a look at the effects of it on the economy so far. For complete coverage on the implementation of the Stimulus, you may visit  http://projects.propublica.org/tables/stimulus-spending-progress

According to ProPublica, which pulled it’s data from the government’s budget, the government has spent $164 billion on it’s projects. An additional $93 billion has been spent on tax cuts. Meanwhile, the remainder of the Stimulus Package is either in the process of being spent, or has not been spent at all. This means that only 28% of the $787 billion Stimulus Package  has been spent. All of the following data is based on the Bureau of Labor Statistics.

• The unemployment rate in January of 2009 was 7.7%. By October 2009, it was up to 10.1%. By the close of the year, unemployment was exactly 10.0%.
• The change in payroll employment went from -741,000 in January of 2009 to -85,000 by December 2009. Output productivity produced by non-farm business went from -8.8% in January of 2009 to +2.9% by September 2009. Manufacturing productivity went from -21.7% in January of 2009 to +8.4% by September 2009.
• Consumer Price Index saw a 0.0% change in prices in January 2009, and a -1.4% change in prices by June 2009. As of November 2009, the index change went up to +1.8%.

Based on this data, the Stimulus Package has improved the economic conditions even though all of it has not been spent yet because it is being spent in stages. The unemployment rate  has seized to worsen and has improved by 0.1% from November. So, unemployment can be expected to decrease. Especially since we have more than just this number to go by. Payrolls were down 741,000 at the beginning of the year, by the end of the year it was only 85,000. Hence we can say that payroll reduction has slowed down significantly, so less and less people are losing their jobs.

At the same time productivity in non-farm businesses went from a decrease of -8.8% year over year, to +2.9% year over year. So, production was basically declining at the beginning of the year, and is finally going up again. If this continues, there is bound to be a demand for more labor, and unemployment should improve. The same can also be said with consideration of productivity in manufacturing  going from -21.7% to +8.4%.

The Consumer Price Index tells us the change in price levels. When price levels go up, it’s because demand for goods and services have gone up. The prices going up is the result of the more money entering the markets. So because the index shows a drop in price levels at -1.4% to an increase price levels at +1.8%, we can say that consumers have gained confidence and spending may continue long enough to create more demand for goods and services. This increased demand would then further increase the productivity numbers, as it would also require more labor, and also bring unemployment down to it’s frictional levels that tend to range around 4% and 5%.

How was effective in the Stimulus Package– very effective!

-Milton Friedman

When Milton Friedman made this statement he was referring to the fact that inflation is dependent on the supply of money. This is illustrated in what is called the quantity equation:

M x V=P x Y

Money x Velocity = Price x Output

Based on this equation, if the government increases spending, the result should be either an increase in prices, or output, or both. In other words, if the government increases spending, it is increasing the amount of money is in circulation within the economy– the money supply– and this will cause increase in price levels, or output.

As we all may know, the Federal Government has already allocated $700 billion to it’s TARP program, of which it has $350 billion left to spend. Meanwhile the government also has set aside $787 billion for the economic stimulus that was passed. This increases government spending by over $1 trillion. With consideration of the current economic situation , which entails a 10 percent unemployment rate and year over year GDP reduction, the aim of spending an additional $1 trillion is to increase GDP and create jobs within the next year. However the likelihood of this  occurring is not very good because this $1 trillion increase in government spending, according to the quantity equation, is not limited to just that effect. It may also cause prices to go up, and increases in prices is nothing other than inflation.

While it is true that inflation is a given at 2 or 3 percent each year, a $1 trillion increase in government spending can cause a much greater rate of inflation in a one year period. Such high levels of inflation is called hyperinflation, and the cause of it is excessive increases in the money supply.

An example of hyperinflation from history would the American Revolution. With the start of the Continental Congress in 1775, the Continental Dollar was also created, and it was a floating currency– fiat money (money that is not backed by any form of commodity). That being the case, the Continental Congress was able to print as much of currency as it needed to finance the American Revolution once it began. In 1775, the value of issued Continentals was $6 million, in 1776 it was $19 million, $63 million in 1778, and finally $125 million in 1779. By the end of the war, the Continental was worthless. and the newly born nation established a new system of commodity money with gold and silver. A similar, but much more extreme story, would be that of Germany in 1923, where inflation averaged 500 percent per month.

Could  present day America really experience hyperinflation though? Aren’t we a developed and well rounded nation? We are actually much more developed, organized, and stronger than we were during the Revolutionary War. The same can be said about present day America and Germany. Nonetheless, here are some things to consider:

Government Revenue 3rd quarter 2009: $3.7 trillion

Government Expenditures 3rd quarter 2009: $5.0 trillion

GDP 3rd quarter 2009: 2.2%

From looking at this, we can conclude that the government is currently operating on a deficit, and at a reasonable level of GDP growth, but should the government be spending an extra $1 trillion? In a worse case scenario, the government might not be able to stir up confidence in individuals and business owners so that they can begin spending so that job availability and production can go up. And maybe the government leaders might even get caught in a cycle of stimulus spending per the demand of it’s constituents for the purposes of re-election. Another case could be that consumers and businesses do increase spending, but at the same time as the government does. Both cases could then flood the economy with too many dollars, and cause the dollar to depreciate uncontrollably.

Some hope, in the light of hyperinflation in the U.S., lies with the Federal Reserve Bank. Should they increase interest rates and sell government securities, they may be able to contract the money supply, in the case that consumers and businesses respond as expected. Some hope also lies with Globalization. If the U.S. experiences no trade barriers from the rest of the world, it is possible for the excess  currency to move into other markets.

- Gregory N. Mankiw, Harvard University

This is the belief that immense government spending is expected to increase interest rates and decrease investments by businesses and individuals. (Keep in mind investments by businesses, in economics, is the purchase of new capital though borrowing of money. Investments by individuals, in economics, is saving money– putting money away in savings accounts, CD’s, bonds, and the like). In order to understand the crowding out effect we have to understand how the government spends money to create this effect. The government does this through borrowing money, an they do this by issuing savings bonds, which are loanable funds. When loanable funds are high in demand, the cost of borrowing, which would be interest rates, is high. When the demand for loanable funds is low, the cost of borrowing is low. When the government chooses to borrow a significant amount of money through issuing bonds, the demand for loanable funds go up. The cost of borrowing is then driven up as a result. Meanwhile, consumers and businesses begin to cut back on spending, and increase their savings because making purchases becomes more costly in terms of opportunity costs. In other words, there is a preference to save due to the higher interest rates that promise a high return. They may also choose to spend less because loanable funds are too costly because interest rates are too high.

As of the third quarter of 2009, the government has spent $5 trillion, receiving only $3.7 trillion in revenue, compared to the first quarter of 2009 with $4.8 trillion in expenditures and $3.8 trillion in revenue (http://www.bea.gov/national/nipaweb/GovView.asp). This includes the $750 billion spent on TARP and war related spending. To add to this, the government plans to increase spending by an extra $825 billion in 2010 in stimulus money (http://www.nytimes.com/2009/01/26/us/politics/26talkshow.html).Despite this, the Fed has not raised interest rates. The direction of interest rates can only be described as a downward spiral since 2008. Does this mean that the crowding out effect just doesn’t work?

No, the crowding out effect does work, just not in a recession. First of all we have to understand that interest rates act as a stabilizer for spending to ensure that there is stable growth– no rapid price increases from too much money being in circulation and no rapid fall in prices from lack of spending (when there is an increase in money in the economy that threatens price increases, then interest rates go up to ensure that there are not price increases; when there is a decrease in money supply and there is threat of a fall in prices, interest rates decrease to ensure that there is no fall). If we were not in a recession, increased government spending would quickly translate into more money in the the hands of individuals and businesses, as both would have the confidence to spend the money that the government puts into the economy from increasing it’s spending. This would then NEED an increase in interest rates. However, there is little confidence right now, hence there is little spending by the consumer and businesses despite the increase in government spending and expected increase in spending. An increase in interest rates in this sort of circumstance will only reduce the likelihood of spending by businesses. As for consumers, they are likely to save even without the incentive of high interest rates. Therefore we can conclude that increased government spending, accompanied by low interest rates is the best that can be done.

- The Buearu of Economic Analysis, Dec. 23 2009

Based on this reporting, we can conclude that the standard of living has actually increased despite the recession that we have been experiencing within the last couple of years. Some say that this is the result of the economy simply coming out of the recession. This is a reasonable explanation because consumption tends to be lower at the height of a recession in comparison to the end of a recession. The same can also be said about income in general. Nonetheless, it is not the only explanation.

Income is the same as GDP and output, all of which are different names for how much a country produces. How mush a country produces depends on how much input is employed, such as labor and capital, which was discussed previously. Considering that there is diminishing returns to scale, there is a particular amount of input that would result in higher productivity, meaning a higher level of output. With this in mind, another explanation for the recent increase in income and consumption may be the result of the productivity maximizing input level being reached. One example from history that suggests this is the increase in wages that occurred in Europe following the Black Death.

Productivity is at its height when the price of inputs is equal to the marginal product of that input. When the Black Death broke out in Europe during the 14th Century, the population was reduced by one-third in just a few years. As a result of this drop in population, there was also a drop in the size of the labor force. What happened next? Marginal product of labor increased, and so did wages, and there was an ultimate increase in living standards as we are seeing today.

Another interesting effect of the decrease in the labor force following the Black Death which can be associated with our current economic situation is the drop in property values. Land income actually fell by fifty percent following the Black Death. In a year over year comparison, we have currently experienced a twenty-seven percent decrease in land income. The difference between the percent drop during the Black Death and today can be due to the fact that income back then was linked to production. However, the cause of the drop in land income is pretty much the same– a smaller labor force means less people to provide income to land owners.

When looking at data from various time periods in U.S. history, we can further confirm the correlation between productivity and income. Below is a chart displaying this connection:

Time Period Growth in Labor Productivity Growth in Income

1959-2003 2.1% 2.0%

1959-1973 2.9% 2.8%

1973-1995 1.4% 1.2%

1995-2003 3.0% 3.0%

Looking at this data, it is clear that there is a positive correlation between productivity and income growth.

In this blog I will talk about the effect of the hiring of labor and the investment of capital on the income of an economy. In particular, you will see that changes in the level of income that goes to labor or capital will alter consumption, and savings (also investments). However, keep in mind that we are holding all other factors in an economy constant. This includes taxes, government spending, and interest rates. Should any of these other factors change, we should have a different effect.

How do companies decide on how much labor and capital to invest in? How much labor a firm hires depends on the Marginal Product of Labor (MPL). The MPL refers to the amount of additional output produced with one additional unit of labor. How much capital a firm invests in depends on the Marginal Product of Capital (MPK). The MPK refers to the additional output produced with one additional unit of capital. In both the case of MPL and MPK, there is increasing returns to scale (where doubled input results in more than doubled output), followed by returns to scale (where doubled input results in doubled output), then diminshing returns to scale (where doubled input results in less than doubled output).

The goal of every business, when investing in labor and capital, is to reach returns to scale. In this case, the cost of hiring an additional unit of labor will be equal to the revenue made from the additional output created by that additional labor. This can be explained below:

Input = Output —> This is what returns to scale would look like. In terms of an extra unit of labor being hired in terms of dollars it would look like the following

Wage = Price of Output—>Here the cost of the extra labor input is the wage that is paid to the extra employee. When there is returns to scale, the wage should equal to the revenue of the extra unit of output.

Likewise, the cost of hiring and additional unit of capital will be equal to the revenue made from the additional output created by that additional capital.

Input = Output —> This is what returns to scale would look like. In terms of an extra unit of capital being hired in terms of dollars it would look like the following

Rental Cost = Price of Output—>Here the cost of the extra capital input is the rental cost, or the monthly payment made for the purchase of the new capital. When there is returns to scale, the Rental cost should equal to the revenue of the extra unit of output.

Based on this we know that businesses will continue to hire labor and capital until they have reached returns to scale, where one additional unit of labor or capital produces one additional unit of output. This is the point where a business maximizes productivity; also where the business is most profitable. (Note that MPL or MPK being equal to the cost of an extra unit of input is not the same as total output costs being equal to total input costs. MPL and MPK is the rate of change in output due to change in input. So when MPL and MPK equals the cost of extra labor or capital, that does not mean that there is zero profit. It means that the change in output revenue covers the costs, the rest of the revenue produced from the extra output is profit.) Once we pass that point of returns to scale, we have diminishing returns– where the change in output revenue is less than costs. Meanwhile, before we get to that point we have increasing returns– where output revenue may cover costs but is not maximized.

What does this returns to scale do to income? Well in a simple model, holding all other factors in an economy constant, it should increase income. This is due to the maximum productivity level, which means a higher level of production through the hiring of more labor and capital. As a result there is higher levels of spending because more people are employed.