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Principles Of Economics
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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:
government spending equals government
tax collections.
► Government budget deficit: government
spending exceeds government tax
collections.
► Government budget surplus: government
tax collections exceed government
spending.
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 growth of real output. To find out
the past growth of output, economists can
study gross domestic product (GDP)
statistics.
► 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)
► This
_↑ _↑
MV = PQ
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: 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
quantity of money.
► 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: fiscal and
monetary policies intended to change aggregate
spending – the prescription of Keynesian
economics.
► 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: a reduction in tax rates will
raise real output – i.e., it will “grow the
economy.”
Definitions (1)
► Tax
► Tax
rate: total tax paid divided by earnings.
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: one in which the tax rate
on higher incomes is greater than the tax rate on
lower incomes.
► 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
of income.
and exemptions of some types
 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.
► 2.
Markets for illegal goods and resources.
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: a curve showing the relationship
between the average tax rate and government tax
revenue.
► 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%.