Principles Of EconomicsPrinciples Of Economics

Power Point PresentationPower Point Presentation Chapter 14Chapter 14

Monetarism and Supply Side Monetarism and Supply Side EconomicsEconomics

► March 16, 2007March 16, 2007

©© J. Patrick Gunning J. Patrick Gunning

Purpose and OrganizationPurpose and Organizationof the Chapterof the Chapter

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

►The two approaches:The two approaches: 1. Monetarism.1. Monetarism. 2. Supply-side economics.2. Supply-side economics.

Overview of MonetarismOverview of Monetarism

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

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

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

Overview of Supply-side Overview of Supply-side EconomicsEconomics

► Keynesian macroeconomic policies seemed to Keynesian macroeconomic policies seemed to have failed to control inflation and have failed to control inflation and unemployment.unemployment.

► The policies reduced the rate of economic The policies reduced the rate of economic growth by neglecting the incentives of the growth by neglecting the incentives of the suppliers of goods.suppliers of goods.

► The supply-siders advocated policies that they The supply-siders advocated policies that they believed would raise producer incentives.believed would raise producer incentives.

► The supply-siders supported monetarism’s The supply-siders supported monetarism’s call for price stability.call for price stability.

New Topic:New Topic: Monetarism Monetarism

►The view that central bank changes in The view that central bank changes in the quantity of money should be the quantity of money should be constrained because, if they are not, constrained because, if they are not, there would be inflation and business there would be inflation and business cycles.cycles.

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

Some DefinitionsSome Definitions

►Balanced budget in governmentBalanced budget in government: : government spending equals government spending equals government tax collections.government tax collections.

►Government budget deficitGovernment budget deficit: : government spending exceeds government spending exceeds government tax collections.government tax collections.

►Government budget surplusGovernment budget surplus: : government tax collections exceed government tax collections exceed government spending.government spending.

A Keynesian PuzzleA Keynesian Puzzle

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

►Suppose that it is financed by Suppose that it is financed by government borrowing.government borrowing.

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

Crowding Out EffectCrowding Out Effect

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

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

DefinitionsDefinitions

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

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

Creating Money To Finance The Creating Money To Finance The DebtDebt

► To avoid the crowding out effect, the central To avoid the crowding out effect, the central bank can monetize the debt due to a deficit.bank can monetize the debt due to a deficit.

► However, what is the difference between However, what is the difference between this and merely increasing the quantity of this and merely increasing the quantity of money to finance additional consumption money to finance additional consumption and government spending?and government spending?

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

► But isn’t this monetary policy?But isn’t this monetary policy?

Money Matters, Money Matters, Say Friedman And SchwartzSay Friedman And Schwartz

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

► Their conclusion: changes in the quantity of Their conclusion: changes in the quantity of money cause changes in the price level and money cause changes in the price level and exaggerate business cycles.exaggerate business cycles.

► Stabilizing the quantity of money will bring Stabilizing the quantity of money will bring economic growth.economic growth.

Friedman’s ConclusionsFriedman’s Conclusions

►Keynesian expansionary fiscal policy Keynesian expansionary fiscal policy that is not financed by an increase in that is not financed by an increase in the quantity of money is ineffective. the quantity of money is ineffective.

►Keynesian policy that is financed by an Keynesian policy that is financed by an increase in the quantity of money increase in the quantity of money causes inflation and may exaggerate causes inflation and may exaggerate business cycles.business cycles.

►Thus, Keynesian policy should not be Thus, Keynesian policy should not be used.used.

Why Does A Government Why Does A Government Increase The Quantity Of Increase The Quantity Of

Money?Money?►Two reasons identified by Friedman:Two reasons identified by Friedman:

1. 1. To finance a budget deficit. 2. To temporarily reduce unemployment.

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

How Should The Central Bank How Should The Central Bank Handle Money? Three Monetarist Handle Money? Three Monetarist

ProposalsProposals►1. Growth in money should equal 1. Growth in money should equal

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

average historical growth of real average historical growth of real output.output.

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

1. Growth In Money Should 1. Growth In Money Should Equal Projected Growth Of Real Equal Projected Growth Of Real

OutputOutput► ↑ ↑ _ _↑_ _↑► (1)(1) MV = PQMV = PQ► If the projections about real output are correct, and If the projections about real output are correct, and

if velocity is constant, an increase in the quantity of if velocity is constant, an increase in the quantity of money that matches the increase in real output money that matches the increase in real output would cause the price level to be constant.would cause the price level to be constant.

► If this policy was successful, it wouldIf this policy was successful, it would 1. Reduce entrepreneurs’ errors due to changes in the 1. Reduce entrepreneurs’ errors due to changes in the

quantity of money.quantity of money. 2. Eliminate the incentive of speculators on durable goods, 2. Eliminate the incentive of speculators on durable goods,

like land and gold, to speculate on changes in the quantity like land and gold, to speculate on changes in the quantity of money.of money.

2. Growth In Money Should Equal An 2. Growth In Money Should Equal An Average Historical Growth Of Real Average Historical Growth Of Real

OutputOutput►The quantity of money should be The quantity of money should be

increased at a constant rate per year increased at a constant rate per year on the basis of the on the basis of the past past growth of real growth of real output. To find out the past growth of output. To find out the past growth of output, economists can study gross output, economists can study gross domestic product (GDP) statistics.domestic product (GDP) statistics.

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

Why Take Away The Why Take Away The Central Bank’s Discretion?Central Bank’s Discretion?

►1. The central bank may make a 1. The central bank may make a mistake.mistake.

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

3. Don’t Change The 3. Don’t Change The Quantity Of MoneyQuantity Of Money

► If economic growth occurs, the argument goes, there If economic growth occurs, the argument goes, there is no need to increase the quantity of money in order is no need to increase the quantity of money in order to keep prices stable. to keep prices stable.

► Financial institutions can make it easier to buy and Financial institutions can make it easier to buy and sell by increasing the amount of credit that they allow.sell by increasing the amount of credit that they allow.

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

► An increase in credit amounts to an increase in the An increase in credit amounts to an increase in the velocity of circulation in the quantity theory of money velocity of circulation in the quantity theory of money equation.equation.

► This idea is part of a new economic thinking about This idea is part of a new economic thinking about money and credit in the era of lightning-fast money and credit in the era of lightning-fast communication.communication.

New TopicNew Topic:: Supply-side Supply-side EconomicsEconomics

►Supply-side economics emerged in the Supply-side economics emerged in the 1970s in the U.S. 1970s in the U.S.

►Main prescription: The goal of Main prescription: The goal of government policy should be to raise government policy should be to raise real output. real output.

Keynesian Vs. Supply-Side Keynesian Vs. Supply-Side PoliciesPolicies

►Demand management policiesDemand management policies: fiscal : fiscal and monetary policies intended to and monetary policies intended to change aggregate spending – the change aggregate spending – the prescription of Keynesian economics.prescription of Keynesian economics.

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

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

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

► The unemployment rate also increased.The unemployment rate also increased.► The rate of growth in real GDP was relatively The rate of growth in real GDP was relatively

low and had recently fallen.low and had recently fallen.► Business activity exhibited periodic ups and Business activity exhibited periodic ups and

downs, although they were not severe.downs, although they were not severe.► It seemed to many economists that demand It seemed to many economists that demand

management policies had failed. management policies had failed.

Historical Inflation, Historical Inflation, Unemployment, and Real GDP Unemployment, and Real GDP

(Figure 14-1)(Figure 14-1)

The Common Sense Of Supply-The Common Sense Of Supply-Side EconomicsSide Economics

► If real output could be raised, economic If real output could be raised, economic growth would occur by definition.growth would occur by definition.

►A rise in real output would reduce A rise in real output would reduce unemployment by increasing the unemployment by increasing the demand for work. demand for work.

►Finally, the quantity equation suggests Finally, the quantity equation suggests that a rise in Q would help to control that a rise in Q would help to control inflation.inflation.

Two Classes Of Supply-side Two Classes Of Supply-side PoliciesPolicies

►1. 1. Tax policiesTax policies designed to raise real output. designed to raise real output.►2. 2. Efficiency policiesEfficiency policies designed to enhance designed to enhance

free enterprise and private property rights free enterprise and private property rights and to improve the efficiency of and to improve the efficiency of government.government.

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

Two Tax Ideas Of Supply-siders Two Tax Ideas Of Supply-siders Discussed HereDiscussed Here

►1. The proposal that real output can be 1. The proposal that real output can be raised by reducing tax rates.raised by reducing tax rates.

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

Proposal 1Proposal 1:: Real Output Can Be Real Output Can Be Raised By Reducing Tax RatesRaised By Reducing Tax Rates

►TheThe proposal:proposal: a reduction in tax rates a reduction in tax rates will raise real output – i.e., it will “grow will raise real output – i.e., it will “grow the economy.” the economy.”

Definitions (1)Definitions (1)

►Tax rateTax rate: total tax paid divided by : total tax paid divided by earnings.earnings.

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

Definitions (2)Definitions (2)

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

►Progressive income taxProgressive income tax: one in which the : one in which the tax rate on higher incomes is greater tax rate on higher incomes is greater than the tax rate on lower incomes.than the tax rate on lower incomes.

►A progressive tax rate implies an A progressive tax rate implies an increasing marginal tax rate.increasing marginal tax rate.

Income And Social Security Income And Social Security TaxesTaxes

►The tax wedge is due to two types of The tax wedge is due to two types of taxes:taxes:

►The income tax. In the U.S., it is The income tax. In the U.S., it is progressive.progressive.

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

Chart 14-1Chart 14-1

Marginal Tax Rate: U.S. Tax Marginal Tax Rate: U.S. Tax BracketsBrackets

(Chart 14-2)(Chart 14-2)

Adjustments Before TaxAdjustments Before Tax

►Deductions and exemptions of some Deductions and exemptions of some types of income.types of income. The case of tax-free interest income on The case of tax-free interest income on

state and local government bonds.state and local government bonds.

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

Supply-sider Argument About The Supply-sider Argument About The Negative Effects Of Taxes On Negative Effects Of Taxes On

GrowthGrowth► High marginal tax rates reduce the amount High marginal tax rates reduce the amount

of work and entrepreneurship supplied and of work and entrepreneurship supplied and they encourage tax avoidance, both legal they encourage tax avoidance, both legal and illegal.and illegal.

► Reducing tax rates, particularly marginal tax Reducing tax rates, particularly marginal tax rates:rates: 1. Encourages individuals to supply more work 1. Encourages individuals to supply more work

and entrepreneurship. and entrepreneurship. 2. Discourages them from engaging in wasteful 2. Discourages them from engaging in wasteful

tax avoidance activities.tax avoidance activities.

Marginal Tax Rate For The Top Marginal Tax Rate For The Top Bracket (Figure 14-2)Bracket (Figure 14-2)

Explanation of Figure 14-2Explanation of Figure 14-2

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

Means Of Legal Tax Means Of Legal Tax AvoidanceAvoidance

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

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

► 3. Shift to do-it-yourself activities.3. Shift to do-it-yourself activities.► 4. Barter.4. Barter.► 5. If business taxes are exempt, become an 5. If business taxes are exempt, become an

independent jobber.independent jobber.► 6. Earn income while living outside one’s country.6. Earn income while living outside one’s country.► 7. Change one’s nationality.7. Change one’s nationality.

Comments On Illegal Tax Comments On Illegal Tax AvoidanceAvoidance

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

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

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

Underground EconomyUnderground Economy

►1. Markets for illegal goods and 1. Markets for illegal goods and resources.resources.

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

The Opportunity Cost Of A The Opportunity Cost Of A Government Project Financed By Government Project Financed By

TaxesTaxes►The cost of a government project that The cost of a government project that

is financed by taxes include not only is financed by taxes include not only the money cost but also the loss due the money cost but also the loss due to taxpayers decisions to supply fewer to taxpayers decisions to supply fewer resources or to engage in tax resources or to engage in tax avoidance.avoidance.

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

New SubtopicNew Subtopic: Tax Revenues May Be : Tax Revenues May Be Raised By Reducing Tax Rates (Figure Raised By Reducing Tax Rates (Figure

14-3)14-3)

A Hypothetical Laffer Curve (symmetric)A Hypothetical Laffer Curve (symmetric)

The Laffer CurveThe Laffer Curve

► Laffer curveLaffer curve: a curve showing the : a curve showing the relationship between the average tax rate relationship between the average tax rate and government tax revenue.and government tax revenue.

► Tax rates of both 100% and 0% would Tax rates of both 100% and 0% would generate no tax revenue for the government generate no tax revenue for the government at all. At 100%, no one would be willing to at all. At 100%, no one would be willing to earn taxable income. earn taxable income.

► For the symmetrical Laffer curve (figure 14-For the symmetrical Laffer curve (figure 14-3), compare the tax revenue at 3% with the 3), compare the tax revenue at 3% with the tax revenue at 97%.tax revenue at 97%.

Another Hypothetical Non-Another Hypothetical Non-symmetric Laffer Curve (Figure symmetric Laffer Curve (Figure

14-4)14-4)

Figure 14-4Figure 14-4

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