Explore BrainMass

Keynesian theory, supply side economics and monetary policy

This content was STOLEN 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 December 19, 2018, 10:40 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.