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Principles Of Economics Power Point Presentation Chapter 14 Monetarism and Supply Side Economics March 16, 2007 March 16, 2007 © J. Patrick Gunning.

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Presentation on theme: "Principles Of Economics Power Point Presentation Chapter 14 Monetarism and Supply Side Economics March 16, 2007 March 16, 2007 © J. Patrick Gunning."— Presentation transcript:

1 Principles Of Economics Power Point Presentation Chapter 14 Monetarism and Supply Side Economics March 16, 2007 March 16, 2007 © J. Patrick Gunning

2 Purpose and Organization of the Chapter Purpose: to present two other approaches to macroeconomic policy that were proposed after Keynes and Keynesianism. Purpose: to present two other approaches to macroeconomic policy that were proposed after Keynes and Keynesianism. The two approaches: The two approaches: 1. Monetarism. 1. Monetarism. 2. Supply-side economics. 2. Supply-side economics.

3 Overview of Monetarism The great depression was the result of the central banks failure to control the quantity of money. The great depression was the result of the central banks failure to control the quantity of money. The central bank had allowed the quantity of money to fall too much. The central bank had allowed the quantity of money to fall too much. Most of the macroeconomic problems can be solved by using the central bank to control the quantity of money. Most of the macroeconomic problems can be solved by using the central bank to control the quantity of money.

4 Overview of Supply-side Economics Keynesian macroeconomic policies seemed to have failed to control inflation and unemployment. Keynesian macroeconomic policies seemed to have failed to control inflation and unemployment. The policies reduced the rate of economic growth by neglecting the incentives of the suppliers of goods. The policies reduced the rate of economic growth by neglecting the incentives of the suppliers of goods. The supply-siders advocated policies that they believed would raise producer incentives. The supply-siders advocated policies that they believed would raise producer incentives. The supply-siders supported monetarisms call for price stability. The supply-siders supported monetarisms call for price stability.

5 New Topic: Monetarism The view that central bank changes in the quantity of money should be constrained because, if they are not, there would be inflation and business cycles. The view that central bank changes in the quantity of money should be constrained because, if they are not, there would be inflation and business cycles. We can see why monetarism became popular in the 1970s by considering a Keynesian puzzle. We can see why monetarism became popular in the 1970s by considering a Keynesian puzzle.

6 Some Definitions Balanced budget in government: government spending equals government tax collections. Balanced budget in government: government spending equals government tax collections. Government budget deficit: government spending exceeds government tax collections. Government budget deficit: government spending exceeds government tax collections. Government budget surplus: government tax collections exceed government spending. Government budget surplus: government tax collections exceed government spending.

7 A Keynesian Puzzle Keynesians advocate the fiscal policy of a government deficit for an unemployment economy. But how is a government deficit financed? Keynesians 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. Suppose that it is financed by government borrowing. Wont this reduce the rate of interest and crowd out business investment? Wont this reduce the rate of interest and crowd out business investment?

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

9 Definitions Monetizing the deficit (debt): creating money to finance a government deficit. Monetizing the deficit (debt): creating money to finance a government deficit. De-monetizing the deficit (debt): destroying money when the government has a surplus. De-monetizing the deficit (debt): destroying money when the government has a surplus.

10 Creating Money To Finance The Debt To avoid the crowding out effect, the central bank can monetize the debt due to a deficit. To avoid the crowding out effect, the central bank can monetize the debt due to a deficit. However, what is the difference between this and merely increasing the quantity of money to finance additional consumption and government spending? 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. New money could be distributed to consumers through a lottery or tax rebate. But isnt this monetary policy? But isnt this monetary policy?

11 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 output over 100 years. Milton Friedman and Anna Schwartz collected and analyzed data on the relationship between the quantity of money, the price level and real output over 100 years. Their conclusion: changes in the quantity of money cause changes in the price level and exaggerate business cycles. Their conclusion: changes in the quantity of money cause changes in the price level and exaggerate business cycles. Stabilizing the quantity of money will bring economic growth. Stabilizing the quantity of money will bring economic growth.

12 Friedmans Conclusions Keynesian expansionary fiscal policy that is not financed by an increase in the quantity of money is ineffective. Keynesian expansionary fiscal policy that is not financed by an increase in the quantity of money is ineffective. Keynesian policy that is financed by an increase in the quantity of money causes inflation and may exaggerate business cycles. Keynesian 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. Thus, Keynesian policy should not be used.

13 Why Does A Government Increase The Quantity Of 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 politician, but they are not good economic reasons. They are political reasons. Both of these actions may help a politician, but they are not good economic reasons. They are political reasons.

14 How Should The Central Bank Handle Money? Three Monetarist Proposals 1. Growth in money should equal projected growth of real output. 1. Growth in money should equal projected growth of real output. 2. Growth in money should equal an average historical growth of real output. 2. Growth in money should equal an average historical growth of real output. 3. Dont change the quantity of money. 3. Dont change the quantity of money.

15 1. Growth In Money Should Equal Projected Growth Of Real Output _ _ _ _ (1)MV = PQ (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 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 If this policy was successful, it would 1. Reduce entrepreneurs errors due to changes in the quantity of money. 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. Eliminate the incentive of speculators on durable goods, like land and gold, to speculate on changes in the quantity of money.

16 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 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 banks discretion and its incentive to estimate the future rate of economic growth. The proposal takes away the central banks discretion and its incentive to estimate the future rate of economic growth.

17 Why Take Away The Central Banks Discretion? 1. The central bank may make a mistake. 1. The central bank may make a mistake. 2. The central bank may respond to political appeals. 2. The central bank may respond to political appeals.

18 3. Dont 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. 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. 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 currency. Thus prices will not fall. Credit is, in some measure, a substitute for currency. Thus prices will not fall. An increase in credit amounts to an increase in the velocity of circulation in the quantity theory of money equation. An increase in credit amounts to an increase in the velocity of circulation in the quantity theory of money equation. This idea is part of a new economic thinking about money and credit in the era of lightning-fast communication. This idea is part of a new economic thinking about money and credit in the era of lightning-fast communication.

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

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

21 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 rate of inflation reported by the government increased almost every year between 1965 and 1975. The unemployment rate also increased. The unemployment rate also increased. The rate of growth in real GDP was relatively low and had recently fallen. 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. Business activity exhibited periodic ups and downs, although they were not severe. It seemed to many economists that demand management policies had failed. It seemed to many economists that demand management policies had failed.

22 Historical Inflation, Unemployment, and Real GDP (Figure 14-1)

23 The Common Sense Of Supply-Side Economics If real output could be raised, economic growth would occur by definition. 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. 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. Finally, the quantity equation suggests that a rise in Q would help to control inflation.

24 Two Classes Of Supply-side Policies 1. Tax policies designed to raise real output. 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. 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. Efficiency policies are usually covered in microeconomics and public finance courses.

25 Two Tax Ideas Of Supply-siders Discussed Here 1. The proposal that real output can be raised by reducing tax rates. 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. 2. The idea that a decrease in tax rates might increase tax revenues to the government.

26 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. The proposal: a reduction in tax rates will raise real output – i.e., it will grow the economy.

27 Definitions (1) Tax rate: total tax paid divided by earnings. 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. 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.

28 Definitions (2) Marginal tax rate: the tax rate on the next unit of income earned. 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. 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. A progressive tax rate implies an increasing marginal tax rate.

29 Income And Social Security Taxes The tax wedge is due to two types of taxes: The tax wedge is due to two types of taxes: The income tax. In the U.S., it is progressive. The income tax. In the U.S., it is progressive. The social security tax, including the medicare tax (about 15% of income, including the employers contribution). The social security tax, including the medicare tax (about 15% of income, including the employers contribution).

30 Chart 14-1

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

32 Adjustments Before Tax Deductions and exemptions of some types of income. Deductions and exemptions of some types of income. The case of tax-free interest income on state and local government bonds. 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. Different incomes may be treated differently: capital gains income vs. personal income.

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

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

35 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. 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.

36 Means Of Legal Tax Avoidance 1. If fringe benefits are exempt from taxation, employers can shift from paying wages to providing high fringe benefits. 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 taxed at a lower rate. 2. Hire tax accountants and lawyers to find loopholes and ways to earn income that is taxed at 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 independent jobber. 5. If business taxes are exempt, become an independent jobber. 6. Earn income while living outside ones country. 6. Earn income while living outside ones country. 7. Change ones nationality. 7. Change ones nationality.

37 Comments On Illegal Tax Avoidance Tax can be avoided by not reporting. There is a contest between the tax avoider and tax collector. 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. 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. Taxes provide a greater incentive to earn income from criminal activities vs. income from legal activities.

38 Underground Economy 1. Markets for illegal goods and resources. 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. 2. Markets in which buyers and sellers do not report taxable income and therefore in which taxes are evaded.

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

40 New Subtopic: Tax Revenues May Be Raised By Reducing Tax Rates (Figure 14-3) A Hypothetical Laffer Curve (symmetric)

41 The Laffer Curve Laffer curve: a curve showing the relationship between the average tax rate and government tax revenue. 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. 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%. For the symmetrical Laffer curve (figure 14-3), compare the tax revenue at 3% with the tax revenue at 97%.

42 Another Hypothetical Non-symmetric Laffer Curve (Figure 14-4)

43 Figure 14-4 For the non-symmetrical Laffer curve, tax revenue is maximized at 22.5%. For the non-symmetrical Laffer curve, tax revenue is maximized at 22.5%.


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