Principles Of Economics

Power Point Presentation Chapter 15

Monetarism and Supply Side Economics

► © November 13, 2007 J. Patrick Gunning

Purpose and Organization of the Chapter ► Purpose: to present two other approaches to macroeconomic policy that were proposed after Keynes and Keynesianism.

► The two approaches:   1. Monetarism.

2. Supply-side economics.

Overview of the Tenets of Monetarism ► 1. The great depression was the result of the central bank’s failure to control the quantity of money.

 The central bank had allowed the quantity of money to fall by too much.

► 2. Most of the macroeconomic problems can be solved by using the central bank to control the quantity of money.

Overview of Supply-side Economics ► ► ► 1. Keynesian macroeconomic policies seemed to have failed to control inflation and unemployment.

 The policies did not control unemployment or inflation and reduced the rate of economic growth by neglecting the incentives of the suppliers of goods.

2. To help deal with these problems, the government should adopt policies that will give producers incentives to increase the supplies of goods.

3. Unexpected changes in the quantity of money are harmful.

New Topic:

Monetarism

► Monetarism : The view that central bank increases in the quantity of money causes inflation and exaggerates business cycles.

► We can see why monetarism became popular in the 1970s by considering a Keynesian puzzle .

Some Definitions

► Balanced budget in government tax collections.

: government spending equals government ► Government budget deficit collections.

: government spending exceeds government tax ► Government budget surplus spending.

: government tax collections exceed government

Federal Outlays and Receipts

History of Federal Debt

Inflation-Adjusted Federal Debt

Federal Debt Per Capital

Real Federal Debt as % of GDP

A Keynesian Puzzle

► Keynesians may advocate the fiscal policy of a government deficit for an unemployment economy. But how is a government deficit financed?

► Suppose that it is financed by government borrowing.

► Won’t this raise the rate of interest and crowd out business investment?

Crowding Out Effect

► This refers to the reduced investment spending caused by a budget deficit that is financed by borrowing in the loanable funds market.

► It seems that the increased government and consumption spending would crowd out investment spending, leaving no effect on aggregate demand.

The Loanable Funds Market

Crowding Out Effect

► For every dollar of the government deficit, a dollar less is spent for business investment and/or household consumption.

► The deficit has no expansionary effect.

► It crowds out just as much spending as it adds.

Definitions

► Monetizing the debt : creating money to finance a government deficit.

► De-monetizing the debt : destroying money when the government has a surplus.

Creating Money To Finance The Debt ► To avoid the crowding out effect, the central bank can monetize the debt due to a deficit.

► Monetizing the debt : creating money to finance a government deficit.

► De-monetizing the debt : destroying money when the government has a surplus.

Creating Money To Finance The Debt ► However, what is the difference between this and merely increasing the quantity of money to finance additional consumption and government spending?

► New money could be distributed to consumers through a lottery or tax rebate.

► But isn’t this monetary policy?

► If the increase in money is unexpected, might it cause a business cycle?

Money Matters, Say Friedman And Schwartz ► Milton Friedman and Anna Schwartz collected and analyzed data on the relationship between the quantity of money, the price level and real GDP over 100 years.

Money Matters, Say Friedman And Schwartz ► They asked: what would happen if, beginning with macroeconomic equilibrium, there is an increase in the quantity of money? ► Their analysis of the data showed that for each major inflation period, there was a corresponding jump in the quantity of money.

Friedman’s Conclusions

► Keynesian expansionary fiscal policy that is not financed by an increase in the quantity of money is ineffective. ► Keynesian expansionary policy that is financed by an increase in the quantity of money causes inflation and may exaggerate business cycles .

► Thus, Keynesian policy should not be used.

► Stabilizing the quantity of money is likely to cause economic growth.

Why Does A Government Increase The Quantity Of Money?

► Two reasons identified by Friedman:   1. To finance a budget deficit.

2. To temporarily reduce unemployment.

► Both of these actions may help a politician, but they are not good economic reasons. They are political reasons.

How Should The Central Bank Handle Money? Three Monetarist Proposals ► 1. Growth in money should equal projected growth of real output.

► 2. Growth in money should equal an average historical growth of real output.

► 3. Don’t change the quantity of money.

1. Growth In Money Should Equal Projected Growth Of Real Output ► ► ► ► (1) ↑ _ _↑ MV = PQ If the projections about real output are correct, and if velocity is constant, an increase in the quantity of money that matches the increase in real output would cause the price level to be constant.

If this policy was successful, it would   1. Reduce entrepreneurs’ errors due to changes in the quantity of money.

2. Eliminate the incentive of speculators on durable goods, like land and gold, to speculate on changes in the quantity of money.

2. Growth In Money Should Equal An Average Historical Growth Of Real Output ► The quantity of money should be increased at a constant rate per year on the basis of the past the past growth of output, economists can study gross domestic product (GDP) statistics.

growth of real output. To find out ► The proposal takes away the central bank’s discretion and its incentive to estimate the future rate of economic growth.

Why Take Away the Central Bank’s Discretion to Determine Past Real Output ?

► Two reasons  1. The central bank may make a mistake.

 2. The central bank may respond to political appeals.

3. Don’t Change the Quantity of Money ► ► ► ► If economic growth occurs, the argument goes, there is no need to increase the quantity of money in order to keep prices stable. Financial institutions can make it easier to buy and sell by increasing the amount of credit that they allow.

Credit is, in some measure, a substitute for money. Thus prices will not fall.

This argument holds that if M is constant, V will change to accommodate a rise in real output so that average prices will not change: MV = PQ.

3. Don’t Change The Quantity Of Money ► An increase in credit amounts to an increase in the velocity of circulation in the quantity theory of money equation.

_ ↑ _ ↑ (1) MV = PQ ► This idea is part of a new economic thinking about money and credit in the era of lightning-fast communication.

Rules vs. Discretion

► Rules vs. discretion debate quantity of money.

: a debate about whether the central bank should follow strict rules or should be allowed full discretion in determining the amount by which to increase or decrease the ► Inflation targeting : a monetary policy that aims to achieve a target rate of inflation, possibly zero. Discretion is required, but the goal is to minimize changes in the price level. It involves no expansionary or contractionary policy.

Discretion vs. Inflation Targeting

New Topic : Supply-side Economics ► Supply-side economics emerged in the 1970s in the U.S. ► Main prescription: The goal of government policy should be to raise real output.

Keynesian Vs. Supply-Side Policies ► ► ► Demand management policies economics.

: fiscal and monetary policies intended to change aggregate spending – the prescription of Keynesian Supply-side policies : fiscal, monetary, and other policies and changes in laws intended to increase real output – the prescription of the supply-siders.

Keynesian economists rephrased this to refer to a shift of the AS curve. However, supply-siders rejected the AD-AS model.

Conditions During The Late 1960s And 1970 In The U.S.

► ► ► ► ► The rate of inflation reported by the government increased almost every year between 1965 and 1975. The unemployment rate also increased.

The rate of growth in real GDP was relatively low and had recently fallen.

Business activity exhibited periodic ups and downs, although they were not severe.

It seemed to many economists that demand management policies had failed.

Historical Inflation, Unemployment, and Real GDP (Figure 14-2)

The Common Sense Of Supply-Side Economics ► If real output could be raised, economic growth would occur by definition.

► A rise in real output would reduce unemployment by increasing the demand for work. ► Finally, the quantity equation suggests that a rise in Q would help to control inflation.

Two Classes Of Supply-side Policies ► 1. Tax policies designed to raise real output.

► 2. Efficiency policies designed to enhance free enterprise and private property rights and to improve the efficiency of government.

► Efficiency policies are usually covered in microeconomics and public finance courses.

Two Tax Ideas Of Supply-siders Discussed Here ► 1. The proposal that real output can be raised by reducing tax rates.

► 2. The idea that a decrease in tax rates might increase tax revenues to the government.

Proposal 1 : Real Output Can Be Raised By Reducing Tax Rates ► The proposal: raise real output – i.e., it will “grow the economy.” a reduction in tax rates will

Definitions (1)

► Tax rate : total tax paid divided by earnings.

► Tax wedge : the difference, due to taxation, between the amount of money that is earned by a resource supplier or entrepreneur and the amount that she will ultimately be able to spend or save.

Definitions (2)

► Average tax rate : the absolute amount of taxes paid during a given time divided by income.

► Marginal tax rate : the tax rate on the next unit of income earned.

► Progressive income tax lower incomes.

: one in which the tax rate on higher incomes is greater than the tax rate on ► A progressive tax rate implies an increasing marginal tax rate.

Income And Social Security Taxes

► The tax wedge is due to two types of taxes: ► The income tax. In the U.S., it is progressive.

► The social security tax, including the medicare tax (about 15% of income, including the employer’s contribution).

Chart 14-1

Marginal Tax Rate: U.S. Tax Brackets (Chart 14-2)

Adjustments Before Tax

► Deductions and exemptions of some types of income.

 The case of tax-free interest income on state and local government bonds.

► Different incomes may be treated differently: capital gains income vs. personal income.

Supply-sider Argument About The Negative Effects Of Taxes On Growth ► High marginal tax rates reduce the amount of work and entrepreneurship supplied and they encourage tax avoidance, both legal and illegal.

► Reducing tax rates, particularly marginal tax rates:  1. Encourages individuals to supply more work and entrepreneurship.  2. Discourages them from engaging in wasteful tax avoidance activities.

Marginal Tax Rate For The Top Bracket (Figure 14-3)

Explanation of Figure 14-2

► Figure 14-2 shows the marginal tax rate for the highest bracket of married couples who jointly filed their tax returns in the U.S. for the past 95 years. Note that the top marginal rate on income fell in 1981 and again in 1985. It is also substantially lower today than it had been during the period between 1933 and 1980.

Means Of Legal Tax Avoidance

► ► ► ► ► ► ► 1. If fringe benefits are exempt from taxation, employers can shift from paying wages to providing high fringe benefits.

2. Hire tax accountants and lawyers to find loopholes and ways to earn income that is untaxed or taxed at a lower rate.

3. Shift to do-it-yourself activities.

4. Barter.

5. If business taxes are exempt, become an independent jobber.

6. Earn income while living outside one’s country.

7. Change one’s nationality.

Comments On Illegal Tax Avoidance ► Tax can be avoided by not reporting. There is a contest between the tax avoider and tax collector.

► Some incomes are not reported because they are earned from illegal activities like drug sales and smuggling.

► Taxes provide a greater incentive to earn income from criminal activities vs. income from legal activities.

Underground Economy

► 1. Markets for illegal goods and resources.

► 2. Markets in which buyers and sellers do not report taxable income and therefore in which taxes are evaded.

The Opportunity Cost Of A Government Project Financed By Taxes ► The cost of a government project that is financed by taxes include not only the money cost but also the loss due to taxpayers decisions to supply fewer resources or to engage in tax avoidance.

► Taxpayers’ decisions to supply fewer resources or to engage in tax avoidance are often neglected.

The Flat Tax

► Flat Tax : a tax on all personal income at the same rate.

► Supply-siders argue that because the flat tax would reduce the tax rate on higher incomes, it would encourage work and entrepreneurship and further reduce the waste associated with tax avoidance and tax calculation.

Substitute a Sales Tax for the Income Tax and Exempt Income Due to Saving ► Some supply-siders argue that a government can raise future real output (promote economic growth) by substituting a sales tax for a tax on income and by exempting interest income and income from corporations from taxation.

► Both of these would, in theory, increase saving (and reduce consumption).

New Subtopic : Tax Revenues May Be Raised By Reducing Tax Rates (Figure 14-4) A Hypothetical Laffer Curve (symmetric)

The Laffer Curve

► ► ► Laffer curve revenue.

: a curve showing the relationship between the average tax rate and government tax Tax rates of both 100% and 0% would generate no tax revenue for the government at all. At 100%, no one would be willing to earn taxable income. For the symmetrical Laffer curve (figure 14-3), compare the tax revenue at 3% with the tax revenue at 97%.

Another Hypothetical Non-symmetric Laffer Curve (Figure 14-5)

Figure 14-5

► For the non-symmetrical Laffer curve, tax revenue is maximized at 22.5%.