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Monetarist, Keynesian, and Supply Side Inflation Cures
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Del curso dictado por University of California, Irvine
Strategic Business Management - Macroeconomics
24 calificaciones
De la lección
Inflation and the Warring Schools of Macroeconomics
Conoce a los instructores
Dr. Peter NavarroProfessor
Paul Merage School of Business
[MUSIC]
We saw in our last module on how inflation can certainly spiral out of control.
Particularly when policy makers try to use Keynesian stimulus to
repeatedly drive the economy below its natural rate of unemployment.
Next question we must address is,
how can inflationary spiral be broken once it has started?
As we shall see in this model, there are considerable differences of
opinion across the warring schools of macroeconomics.
And a variety of possible cures,
quite different political consequences and implications.
[MUSIC]
To the monetarists, the best way to stop an inflationary spiral is simple.
Stop using expansionary Keynesian stimulus policies, and allow the economy
to return to the natural or lowest sustainable rate of unemployment.
But of course, you see the first problem with this monetarist cure.
Even if the upward spiral of inflation is stopped,
there still may be significant inflation.
This is because a higher core rate of inflation has been built into the economy.
Specifically, in this case, even if we stop inflation's upward spiral,
we may still find ourselves stuck at point a3 in the figure.
With a new and higher inertial rate of inflation of 9%.
To solve this problem,
the monetarists believe the cure must be taken one step further.
In particular, the monetarist's solution to an inflationary spiral
is to purposely slow the economy down well below its potential output,
and drive the unemployment rate well above the natural rate.
The monetarist idea here is to wring inflation out of the economy with
a temporary deflationary downward spiral, and maybe even a recession.
Of course,
it's not exactly a great political platform to run on in a democracy.
Let's start a recession so we can stop inflation.
So this is not a solution likely
to be eagerly embraced by any democratically elected government.
[MUSIC]
As for the Keynesian alternative to stopping an inflationary spiral,
it often involves the use of so-called price and wage controls.
[SOUND] Such a system, also called an incomes policy.
The government puts a cap, or ceiling, on prices and wages.
But it's not just that such controls are invariably
politically unpopular that make their use problematic.
It's also that such controls simply may not work.
[NOISE] That price and wage controls often fail,
except in critical situations such as wartime, and a population may unite,
is a lesson everyone from democratically elected presidents to
dictators have learned over the long course of history.
As people use so-called black markets and other means to evade price control.
[MUSIC]
As for a third possible solution,
this is where the school of supply side economics comes into play.
This is a school of economics that first came to prominence in the last century,
during the 1980 presidential election in America.
In that election, conservative candidate Ronald Reagan ran on a supply side
platform that promised to simultaneously cut taxes, increase tax revenues,
and accelerate the rate of economic growth without inducing inflation.
Very sweet macroeconomic cue, indeed.
On the surface,
this supply side approach looked very similar to the kind of Keynesian tax
cuts that had been prescribed around the globe in decades past.
[SOUND] However, the Reaganite supply siders viewed such tax cuts,
not as a Keynesian-style aggregate demand stimulus, but
rather from a very different behavioral and aggregate supply perspective.
Indeed, unlike the Keynesians, the supply siders did not agree.
Such a tax cut would necessarily cause inflation.
Instead, the supply siders believe that people would
actually work much harder and invest much more if they simply
were allowed to keep more of the fruits of their labor.
The end result would be to increase the amount of goods and services the economy
could actually produce by pushing out the economy supply curve.
As illustrated in this by now familiar figure.
You can see as the aggregate supply curve shifts outward from AS to AS prime,
with the drop in the tax and regulatory burdens imposed on businesses.
That real GDP increases from Q to Q prime, and
price actually falls from P to P prime.
Do you see now why this kind of macroeconomic approach is
called supply side economics?
Why it offers the promise, a very sweet macroeconomic
cure to both recession and inflation?
[MUSIC]
In fact, this supply side philosophy is embodied in one of the few formal
theoretical constructs of supply side economics, the so-called Laffer curve.
This Laffer curve named, after American economist
Arthur Laffer, is illustrated in this figure.
[SOUND] Here, we see that the marginal tax rate is measured on the vertical axis.
Total tax revenues are measured on the horizontal axis.
Now here what is so very interesting about the Laffer Curve.
Note that it is backward bending.
This backward bending Laffer Curve reflects the behavioral notion
that at some point, people will work less the more they are taxed.
Let me repeat that, because it is very important.
The Laffer Curve reflects the idea that as the tax rate rises,
it will eventually get so high that people will actually begin to work less.
[SOUND] Here's the really key point.
This backward bend in the Laffer curve means that above a certain tax rate,
an increase in the tax rate will actually cause overall tax revenues to fall.
[SOUND] Looking at the figure, at what tax rate will a further increase
in the tax rate actually reduce, rather than raise tax revenues?
Please jot down your answer before moving on.
[MUSIC]
Now, here's an equally interesting key point.
For a supply side tax cut to actually increase tax revenue,
as Ronald Reagan promised,
the existing tax rate before the tax cut must be above point M on the Laffer Curve.
Say at a rate associated with point n.
[SOUND] This is, indeed, a key point, because in the early 1980s,
the Reagan Administration simply assumed that the economy was,
in fact, the backward bending portion of the Laffer Curve,
and that a tax cut would increase total tax revenues.
Based on this assumption,
it moved forward with one of the largest tax cuts in American history.
The corporate tax rate was cut by 25% over three years.
The top marginal tax rate on the wealthy fell from 50 to 38%.
As part of its supply side program, the Reagan administration also
cut back sharply on the regulation of everything from monopoly and
oligopoly to pollution and product safety.
Important elements that likewise affect the aggregate supply curve.
The next obvious question is,
did this supply side experiment work?
[MUSIC]
The answer to this question is a difficult one, but
here's at least some of what we know.
The Reagan years did indeed witness significant declines in both inflation and
interest rates,
while America enjoyed what at the time was a record long peacetime expansion.
On the surface, this would seem to argue for a favorable shift in the aggregate
supply curve, due to Reagan's supply side policies of deregulation.
However, the promise of tax cuts leading to increased tax revenues
never materialized.
Instead, as the American economy boomed under Reagan, so
too did America's budget deficits.
And this evidence suggests, with no small irony, that the Reagan tax cuts
behaved much more like a liberal Keynesian stimulus than a pure and
conservative supply side effect.
Either way, there's a third important school of macroeconomics,
joining the Keynesian monetarist schools.
Supply side economics has become an important part of the macroeconomic
lexicon.
An important tool for many governments around the world to use.
In the next module, we will look briefly at yet
a fourth school of macroeconomics, known as New Classical Economics.
And this should be a fascinating glimpse at a more forward way of looking
at the world of macroeconomic policy through the lens of rational expectations.
The behavioral model of expectations that we briefly discussed earlier.
When you are ready, let's move on.
[MUSIC]
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