Lecture 20

Policy Debate
 Activism and nonactivism
the important distinction
Kemp: nonactivist “supply sider”. govt
has very limited role
Gore: activist - prefers broader
approach to demand and supply
policies. govt has a role
basic issue: how should policymakers
respond to inflationary and
recessionary gap situations as they
arise. ECON
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 The Kemp Camp

The following describes the economic

positions most often associated with
the most Republican candidates.
I will take on the persona of a stauch
Republican supporter in this
discussion
 ECON
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Kemp: MACRO HAPPENS

A view from the supply side

Origin: the Classical laissez-faire position
that government should have a very limited
role in the market place.
Quite simply: If supply determines the
capacity of the economy, then
shouldn’t we craft policies aimed at
increasing supply?
 ECON
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Basic Tenents of the Supply Side

MACRO HAPPENS

Demand side Policies Don’t Work

Keynesian economics fails to recognize the
role of supply in determining RGDP
Tax Cuts have a magical positive effect on
the economy
Tax Revenue that is “lost” due to the tax cuts
will be replenished with the massive
growth that will take place in the economy
 ECON
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Why don’t Demand Side Policies Work

1. Focus on the Demand side implies we must

chose between unemployment and inflation
2. Most government spending crowds out
initiatives that would have taken place in
the private sector anyway
3. Governments spend money unwisely and
diverts resources to unproductive areas
4. The economics of “tax and spend” don’t
make sense
 The Magic of Tax Cuts

1. cut taxes everywhere

2. eliminate regulation
3. Government’s role is to create an
environment conducive to business
expansion and get the hell out of the
way
4. laissez-faire policies
5. Don’t stifle private enterprise ECON
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 Taxes are the one true evil in our
economy
High Taxes are responsible for virtually
all of California’s Problems
High Crime Rates are caused by the
overburdens government places on
individuals(taxes are to high,
regulation is too cumbersome)

ECON
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 The Track Record for the Supply Side

Ronald Reagan is the champion of our cause

Reagan “proved” that supply side policies
result in massive growth in the economy
The 1980’s were much better than the 1970’s
because of Supply Side Policies
Look at the Data on Economics in Action
review growth in RGDP in the 1980’s in EIA

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 A Supply Siders Interpretation of
AD and AS
Go to Economics in Action AD/AS module
click on the Tool Kit Option
To a Supply sider, the economy is always at
or very near the LRAS curve.
Recessions are self-correcting
Hence no Policy is needed and any attempt
to intervene is unwise and usually counter
productive
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 ECON
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This is a temporary, self correcting situation
we dont need govt to fix it.
Supply side remedies to a
recessionary gap situation.
LRAS
price SRAS

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AD
RGDP
Over time wages will fall and the supply curve will shift to the right.
The economy is naturally self correcting.
 Supply side and Growth

The formula for growth is simple. Recall the picture

of the production function
promote savings to fuel capital formation
individual ingenuity to promote technological advance
The key policy element here are tax cuts
let individuals and firms make the decisions. govt
should have limited role.
govt makes bad choices, space program, SST, oil
shale, the list goes on. (Think about Japan)
 Think about the fundamental
ingredients in growth and liken it to
cooking a fine dinner
What do we need to prepare a fine
dinner
labor (the cook)
raw materials (the ingredients)
capital (utensils and oven)
knowhow (recipe)
There is no way we can continue to
improve the quality of the dinner
without the proper incentives.
Government and incentives

Do you believe that only government can

organize this task?
Do we rely on government to provide the
ingredients and recipe or should markets
and the private sector lead the way?
Individuals need incentives (low taxes and
deregulation) to produce quality “dinners”
and grow the economy
 ECON
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Supply Side Policy MACRO HAPPENS

Prescriptions
1. Capital gains. A capital gains tax cut
is designed to encourage business
investment in plant and equipment
and thereby increase supply.
2. Flat tax. High tax rates paid by high
income people stifle incentives. We
must lower tax rates --especially at
the high end to promote incentives.
 Summary of the supply Side position

Demand Management is a bad idea

Tax Cuts are the only policy to pursue
illustrate with AD/AS (SR and LR) ECON
practice with EIA tool kit 111
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What is the Evidence MACRO HAPPENS
California, Reagan years(compare 70’s with 80’s)
 Enter the Gore Position

The following describes the economic

positions most often associated with
the most Democratic candidates.
I will take on the persona of a stauch
Democratic supporter in this
discussion
 The Basis for Activist Policy

Establish the modern Keynesian or

neo-Keynesian position
Demand management should be used
as one tool to deal with natural
business cycle fluctuations.
Laissez-faire was the thinking that led
to the Great Depression
ECON
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 Activism: Basic Tenents

Coordination ECON
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demand and supply HOFFMAN
MACRO HAPPENS
govt and business
tax cuts are often politically motivated,
benefit only the rich and lead to
income inequality.
The standard AD and AS story we have
learned is applicable. Many factors
matter.
What is Wrong with Cutting Taxes

Is only one of many tools

most tax cuts don’t lead to enough
“trickle down” benefits
“tax and spend” is at least more
honest than “cut taxes and borrow
from the future.80’s tax cuts forced
hard choices in the 1990’s
Clinton budget is balanced despite
interest on Reagan debt ECON
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 A Neo-Keynesian View of the
Reagan Years ECON
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Tax Cuts mostly Benefited the Rich
MACRO HAPPENS
working class taxes went up
Taxes were cut but Government Spending
was Not. Deficits will be a lasting burden.
Keynesian economics would have also
predicted expansion
Oil price fluctuations killed the 1970’s and
made Reagan look good in the 1980’s -- He
was lucky!!(look at EIA) Do on your own
 Things to Look at in the Data

Consider UN and Inflation

Look at
tax revenues and government spending
deficits
oil prices
What effect do changes in oil prices
have on AD and AS curves?
review EIA on this point
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 A summary of Reagan Bush
(from the activist perspective)
“tax and spend” was replaced by
“borrow and spend”
tax cuts benefited the rich
government spending was slashed for
certain social programs but not
defense, or money for the elderly
most economic gains are explained by
the massive decline in oil prices
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Lets revisit the Cooking the
Fine Dinner Story
Government can play a very important
role.
Educate the Cook
Provide R&D support to improve
technology of ovens/utensils
Subsidize production of ingredients
Be the catalyst for the recipe (Knowhow)
There is more to the Supply
Side than Tax Cuts
recall our discussion of growth
what role does education play?
Govt Leadership is sometimes important.
Would the private sector have created:
space program
internet
Government may play an important role
in expanding the supply side of the
economy. ECON
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 End of Debate

Now lets summarize the two positions

 Illustrating the positions with AD
and AS Curves
LRAS
Price SRAS
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AD
RGDP
How does an activist propose to remedy the situation?
How does a nonactivist propose to remedy the situation?
Do tax cuts or better educated labor force lead to LR growth?
 ECON
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Summary :Gore MACRO HAPPENS

Activist: Demand and supply play a role in

the determination of RGDP. Must
coordinate activities and use policy tools to
manipulate supply and demand
Long-run growth is obtained by building
human capital (education/skills)
govt should provide funds
Gore’s new industrial policy: attempt to target
certain industries for tax breaks
GOVT must assume substantial responsibility
 Nonactivist(supply-Sider) Kemp

Laissez-faire is the best policy. In the

Long-run economic growth can be
encouraged by reducing taxes.
Private Sector Consumption will make
up for any loss in government
purchases. Letting individuals and
firms make choices, not govt, is the
ticket to short and long-term ECON
prosperity. 111
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MACRO HAPPENS
 What is the effect of higher
taxes in AD/AS
The Kemp position is that taxes curb
growth and that low taxes are the
essential ingredient for growth
The Gore position is that taxes are
negative for growth but are justified if
they provide education/training that
is essential for growth
 Supply-Side Effects of the Income
Tax
The Labor Market
LS+tax
LS

Income
15 per hour)
eal wage rate (dollars tax
14

10
LD

210 230
Quantity of labor (billions of hours per year
 Supply-Side Effects of the Income
Tax
The Capital Market

KS

al interest rate (percent per year)

6

4
KD

13 14
Quantity of capital (trillions of 1992 dollars
 Supply-Side Effects of the
Income Tax
KS+tax The Capital Market

KS

Income
al interest rate (percent per year) tax
6

4
KD

13 14
Quantity of capital (trillions of 1992 dollars
 Fiscal Policy and
Aggregate Supply
Supply Effects and Demand Effects
A tax cut increases both aggregate supply
and aggregate demand.
There is disagreement about which effect
is larger.
A tax cut increases real GDP, but it can
either raise or lower the price level.
 Two Views of the Supply-
Side Effects of Fiscal Policy
150

SAS0
Price level (GDP deflator)

115
110 The Traditional View
“Gore”

90
AD0

7 8 8.8 9 10
Real GDP (trillions of 1992 dollars)
 Two Views of the Supply-
Side Effects of Fiscal Policy
150

SAS0
Price level (GDP deflator)

115
110 The Traditional View
“Gore”

90
AD1
AD0

7 8 8.8 9 10
Real GDP (trillions of 1992 dollars)
 Two Views of the Supply-
Side Effects of Fiscal Policy
Fiscal policy has a large
effect on AD and a small
150 supply-side effect

SAS0
Price level (GDP deflator)
SAS1
115
110 The Traditional View
“Gore”

90
AD1
AD0

7 8 8.8 9 10
Real GDP (trillions of 1992 dollars)
 Two Views of the Supply-
Side Effects of Fiscal Policy
150

SAS0
130deflator)
Price level (GDP

110 The Supply-side View

Kemp

90
AD0

7 8 9 10
Real GDP (trillions of 1992 dollars)
 Two Views of the Supply-
Side Effects of Fiscal Policy
150

SAS0
130deflator)
Price level (GDP

110 The Supply-side View

Kemp

90
AD1
AD0

7 8 9 10
Real GDP (trillions of 1992 dollars)
 Two Views of the Supply-
Side Effects of Fiscal Policy
Fiscal policy has a large
150 effect on AD and a large
supply-side effect

SAS0
130deflator)
Price level (GDP

SAS1
110 The Supply-side View
Kemp

90
AD1
AD0

7 8 9 10
Real GDP (trillions of 1992 dollars)