All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

Answers for the Day
1980s: Supply-side Economics

1. Are we ready for a little more complication in your macro model? One reason to do it is that it allows us to help explain the emergence of Ronald Reagan on the national political scene. He seized the moment, he identified the 'wave' of public sentiment and rode it into the White House. The problem was that there was no leadership on the economy which was suffering through a second case of stagflation within a decade?  What was the problem that he proposed to fix? Please demonstrate the situation with AS-AD diagrams.

The US economy was suffering from both serious unemployment (stagnation) and serious inflation - a situation we call stagflation. The primary cause was the significant oil price increases of OPEC in the early and late 1970s. Because oil is an important input into the production of many goods and services, this price increase raised the cost of production which we would present as a left ward shift (decrease) in the AS curve. As you can see, the result is an increase in the price level (inflation) and a decrease in output (stagnation). This is what Reagan said he would cure - and he would do it with 'supply-side' policies-policies designed to shift the AS curve back to the right.

2. And how did he propose to solve stagflation? Identifying the problem is only half the battle. What can we do to solve the problem? What was the name given to his 'package' of reforms designed to right the course of the American economy? Please use the diagrams from class to demonstrate the Reagan solution to our problem.

It should be clear from the diagram below that the demand-side policies favored by economists in the 1970s could not 'cure' the problems. The supply shock caused output to fall (Q* to Q1) and prices to rise (P* to P1). An increase in demand (left-side diagram) would be proposed by those who were very concerned with the lower level of output. They would design a policy to shift out the AD curve (green line) which would restore the value of output (Q2), but at a cost of even higher prices (P2>P1).

Now what about those most concerned with inflation. They would propose policies to shift the AD curve inward. The result would be a return to the lower price level (P2), but at a significant cost in terms of lower output (Q2<Q1).

So what do we do? It should be obvious-let's shift out the supply curve.  And just for good measure, let's call it Supply-Side Economics.

3. Ronald Reagan led a revival of the conservative movement in the presidential election of 1980. What were the three key pieces of the conservative agenda and what were the problems associated with the achievement of each one?

The conservative movement that had three key elements on its agenda: reduce inflation, balance the budget, and reduce the size of the government.  There was a political problem, however, with each piece of the agenda.   Significant reductions in inflation would require substantial increases in unemployment - the old Phillips Curve tradeoff.  Balancing the budget, meanwhile, would mean that tax cuts - a favorite Republican proposal - would be impossible to achieve.  The budget could not be improved with substantial cuts in government spending without a loss in benefits received from the government. 

4. George Bush called Reagan's economic policies "voodoo economics" while Herbert Stein called them "the economics of joy." Both individuals were reacting to Reaganomics' painless solution to stagflation. What were the roles of the Arthur Laffer and Robert Lucas in Reagan's solution?

The Reagan solution was grounded in three ideas that were circulating at the time.

1. There is no link between inflation and unemployment.
2. There is no "cost" in terms of reduced benefits to reduced government spending.
3. The budget can be balanced with a tax cut.

Robert Lucas provided the solution to the first problem while Arthur Laffer provided the solution to the third problem.  In a world with rational expectations, inflation could be quickly and painlessly eliminated as long as policy officials had credibility. In this world there would be no Phillips Curve type trade-off between inflation and unemployment.  Arthur Laffer provided the Laffer Curve that "proved" tax revenues could increase with a decrease in tax rates. This allowed Reagan to propose tax cuts as a way of balancing the budget. 

5. Output in an economy can be expanded by increasing the level of resources or the productivity of those resources.  What were the 'pieces' of Reagan's economic package and how did they all work together to increase the supply of resources and productivity?

What are the factors that will lead to an increase in supply? A good place to start is by recognizing that we use labor and capital (offices, factories, machines) to produce output. His plan was to increase both of these. He was increasing capital by making investment spending more attractive with tax policies targeted at investment (investment tax credit and accelerated depreciation), and policies designed to increase the pool of funds available to businesses by raising the incentives for households to save (lower taxes on wealthy and individual retirement accounts). To increase the labor supply, he wanted to make not working less attractive by lowering benefits to the unemployed and poor and by lowering taxes on workers so they would want to work more.

6. Please explain the significant differences between the inflation caused by the military build-up for Vietnam in the late 1960s and the inflation caused by the OPEC price increase in the early 1970s.[you may want to use the AS-AD model].

The sources of inflation were very different. As we see above, the 1970s inflation was caused by an inward shift in the AS curve. The result is lower output and higher prices. In the 1960s, however, the US was conducting the Vietnam War which raised aggregate demand. The result here was also higher prices, but now there was higher output.

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