Explore BrainMass

Explore BrainMass

    Keynesian theory, supply side economics and monetary policy

    This content was COPIED from BrainMass.com - View the original, and get the already-completed solution here!

    I need help with an article. I need a two to three paragraph real people explanation on this article and what he is saying about the theories of using fiscal policy and which theory would be the most supportive and why? the article is listed below:

    While Keynes revolutionized economic thinking in the 1930s, his theories were subsequently eclipsed by new ideas such as monetarism and supply- side. But the tumultuous 1990s have seen the re- emergence of Keynesianism as a policy prescription of choice. This is the third and final part of our article on economic schools of thought.

    AS I have described in my last two articles, John Maynard Keynes, a

    British economist, captivated the world in the 1930s with fresh ideas that

    revolutionized economic thinking following the Great Depression. His

    arguments for an active government role in stabilising economic cycles

    became an eye-opener for policy-makers who, at one time, were obsessed

    with the classical ideology, which believed in market efficiency.

    In spite of the emergence of this new and appealing economic thinking,

    some remained sceptical. Monetarists like Milton Friedman and many other

    `Chicago Boys' from the University of Chicago were not impressed and

    opposed to the idea of government messing around with the free- market


    Later, economists like Robert Lucas with his rational expectations idea

    strongly argued against Keynesianism by insisting that government

    intervention would do nothing but harm to the economy.

    While economists were debating over a suitable policy recommendation,

    the United States economy was deteriorating towards the end of the 1970s.

    Inflation induced by two oil shocks (in 1975 and 1979) remained high and

    productivity slumped. Distortions and lack of incentives created by over-

    regulation and high taxes were partly blamed for the drop in productivity.

    The criticism of Keynesian economics and the lack of success in

    monetarism as an alternative policy tool led to a search for new economic

    ideas. That was the time Ronald Reagan was swept into the White House.

    Reagan was a lucky man. By the time he challenged Jimmy Carter in the

    presidential election of 1980, the US economy was badly in need of new and

    bold ideas to overcome problems of escalating inflation and declining

    productivity. Reagan took this opportunity to push for supply- side

    economics or Reaganomics which was (and still is) not in line with

    mainstream ideas.

    Supply-side economics, arguably, were ideas that emerged in the 1970s.

    As described by its name, the supply-siders disagree with the notion that

    demand-side policies are important. Monetary policies are not seen as

    effective in helping economies recover.

    According to its proponents, supply will create its own demand (what

    economists often refer to as Say's Law) because money has to be spent on

    something. Therefore, there should not be such cases as demand failure as

    proposed by Keynesian economics.

    The other startling argument is related to the claim by supply- siders

    that there would be a dramatic rise in work incentive if taxes were

    substantially lowered. Conventional ideas would say that tax revenue would

    decline if taxes were cut. That would make sense. In other words, total

    revenue should have a positive correlation with the tax rate.

    But this new group of economists argued the other way round - that tax

    reduction would drastically boost economic activity up to a point that tax

    revenue would actually increase!

    This may initially sound incomprehensible, but the proponents actually

    came up with a graphical representation (known as the Laffer Curve) that

    supported their argument. The curve, named after economist Arthur Laffer,

    depicts a relationship between tax rate and revenue.

    According to supply-siders, at an initial phase, tax revenue would

    naturally rise in tandem with the increase in tax rate, producing an

    upward-sloping curve. At one point, however, people would get discouraged

    when tax rates get too high. Hence, they would reduce their working hours

    and, as a result, tax revenue would fall. This would cause the upward-

    sloping curve to turn downward.

    Subsequently, within this range of a backward-sloping curve, it would be

    beneficial to cut taxes to increase tax revenue.

    Laffer scored some points there. But even as a graduate student back in

    the 1980s, I was asking the same question that the man-in-the- street would

    ask: how do we know when the economy is in this downward-sloping range? It

    would be tough to determine this.

    Secondly, with the benefit of hindsight, we can now argue that cutting

    taxes did not increase tax revenue during the Reagan years. In fact, the

    budget deficit, which was at a manageable level prior to 1980, started to

    bloat under the Reagan Administration and became a hot topic of

    presidential debates in 1984 and 1988.

    The supply-side proponents, however, maintained that the Reagan years

    were a successful period and that George Bush's defeat to Bill Clinton in

    1992 was due to his failure to continue with Reagan's economic policy.

    After a deep contraction in 1982, the economy managed to post a growth

    rate in excess of 6% in 1984. Robert Mundell, an economist well- known for

    his Mundell-Flemming model (a basic ingredient for international economic

    studies), is widely regarded as the person behind the supply- side theory

    that Reagan used to turn the economy around from the allegedly disastrous

    Carter policies.

    There is, however, a lot of disagreement among economists as to whether

    Reaganomics actually brought any significant changes to the US economy. In

    spite of this, supply-side was indeed one of the most popular subjects

    among economists in the 1980s, not only because of its fresh new

    approaches but also because of the controversy that it brought to the

    world of economics.

    By the 1990s, most people thought Keynesian would no longer be a popular

    subject among economists. But things soon went the opposite direction

    again. The love affair with Keynesian economics began to blossom again and

    policy-makers started to fiddle with its policy prescriptions.

    For instance, many Asian countries resorted to public spending after

    their economies succumbed to the financial crisis in 1998, leading to a

    significant rise in budget deficits.

    Malaysia, for instance, has incurred budget deficits for five

    consecutive years following the economic slowdown and pump- priming by the

    government. Thailand and the Philippines also experienced the same thing.

    In northern Asia, Japan's economic malaise resulting from the property

    burst in 1990 also led to an increase in public-work spending.

    How and why did Keynesian policies re-capture the hearts of so many

    policy-makers? My opinion is that Keynesian is too irresistible to ignore,

    especially by politicians.

    When an economy is in bad shape, voters would expect politicians to do

    something. Those who believe in totally free market forces would be

    tempted to just sit around and let nature take its course. Unfortunately,

    voters will not vote for this kind of people. Policy-makers have to, at

    least, be seen to do something.

    Secondly, in the early 1990s, the so-called new Keynesian economics

    emerged, arguing against rational expectations, while proposing government


    Basically, this new idea believes that most irrational outcomes in the

    marketplace are a result of an interaction between imperfect competitive

    markets and less than perfectly rational individuals - people are simply

    not rational in their decision-making.

    In such circumstances, active monetary policy is required because

    recessions represent a market failure that can be corrected by government


    It is quite interesting to see how all these theories and their

    applications have evolved over time. Most of these economic ideas were

    tested over and over again before they became acceptable to policy-makers.

    Most were also subjected to constant challenge as time went by.

    Those that got into trouble usually either worked in theory but not in

    practice or worked in practice but not in theory. As time goes by, more

    new ideas will emerge while some old ideas will re-emerge. Time will tell

    whether these ideas can really explain how the economy works.

    © BrainMass Inc. brainmass.com October 9, 2019, 6:44 pm ad1c9bdddf

    Solution Preview

    The author is discussing and contrasting three theories. One is the Keynesian theory that recommends government fiscal intervention in reducing the effects of economic cycles. The second is monetarism and the third is the supply-side economics. Keynesian economics and its application would mean that the government would have to interfere in the free market economy. Milton Friedman and the other monetarists did not advocate this. On the other hand Say's law that ...

    Solution Summary

    Keynesian theory, supply side economics and monetary policy is discussed on the context of the US economy.