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Chapter 16 Stagflation and the Rise of 
Supply-Side Economics

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I. Understanding Stagflation
    A. Keynesian interpretation
        1. Inflation and unemployment change in opposite directions
        2. Correlation existed for four decades and was depicted by
            English
economist A.W. Phillips in what became known 
            as the Phillips Curve.
            a. He depicted an inverse relationship between changes in
                wages and changes in unemployment.
            b. Today the Curve is used to depict changes in consumer
                prices and unemployment.
            c. The Curve points out the inconsistency of both low
                unemployment
and low inflation as economic goals. 
            d. A trade-off between the
two is required because 
                the factors necessary for low unemployment cause 
                high inflation and vice versa.
            e.
The Phillips Curve Key Cibcepts in 60 seconds
        
   f. Will the Real Phillips Curve Stand Up 04/04/11

 

 

Edmund-S-Phelps-and-the-Phillips-Curve

 

   B. Stagflation of the 1970's
       1. High unemployment and high inflation during the 1970's was not easily
           explainable with Keynesian
theory which emphasized aggregate demand.
       2. High
unemployment caused by low aggregate demand typically results in
           low inflation.
       3. The Phillips Curve had moved to the right during the 1970's as both inflation
           and unemployment increased.
           a. Prices increased primarily because AS had decreased (shifted left).
           b. Unemployment increased because of slow growth in aggregate demand.
   C. The current and historical Misery Index
   D. Check out AP Macroeconomics Review Materials!

II. The origin of stagflation during the 1970's
     A. OPEC monopolized oil prices.
     B.  Inflationary psychology, the feeling that prices would always increase substantially, resulted 
          because of the
high inflation during the Vietnam War and OPEC price fixing. To some 
          degree, society acquiesced to inflation.
     C. Wage-price controls put on in the early 1970's to artificially limit the Vietnam War inflation
          were lifted. Once these artificial constraints to
market activity were removed, prices 
          increased dramatically.
     D. Productivity declined because of an influx of inexperienced workers (baby boomers and 
        women) and the transformation of our economy from a manufacturing base (with its high 
        productivity) to a more service-oriented base with its low productivity.
III. The misery index,
which equals the unemployment rate plus the inflation rate, is an 
       attempt to measure overall economic well-being. (Data from 1991 and 2000 Economic 
       Report of the President, 1992 Statistical Abstract of U.S., Economic 
       Trends published by the Federal Reserve Bank of Cleveland and Federal Reserve Estimates.
       Data was averaged by the author with the 1940's average taken from years 1941-1950, etc.

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Misery Index by Year

(1948 to 2010)

Unemployment Rate

By Year (1948 to 2010)

Inflation Rate

By Year (1948 to 2010)

 

 

 

 

 

 

Misery index from - Wikipedia has interesting information.

Unemp. Inflat. MI   
2001 4.76 2.83 7.59
2002 5.78 1.59 7.37
2003 5.99 2.27 8.26
2004 5.53 2.68 8.21
2005 5.08 3.39 8.48
2006 4.63 3.24 7.87
2007 4.61 2.85 7.46
2008 5.76 3.85 9.61
2009 9.26 -0.34 8.29
2010 9.64 1.64 11.29

 

Adding Short-Term Interest Rates shows an even a larger drop!
Graph is from tuitor2u.com.

IV. Supply-side economics originated because of stagflation
      A. Supply-side economics described three key problems causing
           slow economic growth.
          1. High taxes are the fundamental problem, especially high 
              marginal rates.
              a. They decrease incentive to work and save.
              b. They cause cost-push inflation.
          2. High transfer payments lower worker incentives.
          3. Government regulation is expensive and counterproductive.
     B. Solving these problems would stimulate high noninflationary 
          economic growth by increasing AS. 
     C. Here is one estimate of the cost of government regulation.
     D. For the cost of regulation visit 

           Office of Advocacy,US Small Business Administration, The Impact

Total Regulatory Costs (billions of current dollars)

Regulatory Costs per Family (1988 dollars)

 

 

 

 

 

 

1977

433

1980

5,172

1981

418

1984

4,458

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1986

369

1988

4,078

1991

400

1992

4,272

From "Regulations' Staggering Costs" by David Warner, published in Nations Business, June 1992. Family data printed in the article from Thomas D. Hopkins, Professor of Economics, Rochester Institute of Technology.

V. Reaganomics
    A. President Reagan attempted to eliminate the causes of stagflation by instituting supply-side
         economic policies.
    B. These were the key ingredients of President Reagan's economic policy.
        1. Supply-side policies
            a. Lower government expenditures on social programs
            b. Reduce government regulation 
            c. Cut personal and corporate taxes, especially high marginal tax rates
        2. Monetary policy: President Reagan did not discourage the Federal Reserve from their
            continued attempt to lower inflation with a tight money policy.
    C. Keynesian economics predicted lower taxes would increase the already high rate of 
         inflation.
    D. Many predicted high deficits, economist Arthur Laffer disagreed.
        1. Laffer Curve
        2. Lowering the tax rate from X to X' would increase tax receipts.
            a. Lower tax rate would lessen avoidance of taxes.
            b. Fewer transfer payments due to tougher welfare policies would result in more
                people working and paying taxes. 
            c. Overall effect of the program would be higher productivity. This would increase
                AS causing GDP and tax revenue to increase.
        3. The  Laffer Curve- Economic Theories in 60 seconds


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VI. Analyzing the effectiveness of Supply-Side Economics as applied by Ronald Reagan
      A. Contractionary effects of tight money came earlier than the expansionary effects
           of a tax cut and the result was two recessions from 1980-83.
      B. Short-term results were good.
          1. Inflation dropped dramatically although much of the credit must go to the Federal
              Reserve which began tightening in 1979.
          2. Unemployment eventually came down.
          3. The longest peacetime expansion in history resulted although critics point out that
              the large increase in military spending during the early Reagan years made for high
              peacetime defense budgets.
     C. Supply-side effects may have been negligible.
          1. Aggregate supply moved little as productivity increases were small. 
          2. Saving went  down (though much of the drop in saving had demographic causes
              as baby boomers borrowed to furnish homes, many of which were investment
               type multifamily dwellings.
     D. Some results seemed bad, especially at the time.
          1.  Large federal deficit resulted (in part because inflation came down much faster
               than expected lowering tax revenues).
               Many felt these deficits would compete with (crowd out) private investment for
                many years.
          2. The trade deficit increased. 
              a. The problem began when an increase in borrowing by businesses, individuals,
                  and the federal government caused high interest rates. 
              b. High interest rates combined with a drop in inflation and an economic recovery
                  making U.S. investments attractive.
              c. The resulting high foreign demand for the dollar pushed its value up making
                  imports cheaper and exports more expensive.
    E. Opinions differ as to the overall result.
        1. Some think the recovery was a typical Keynesian demand-side phenomenon
            (i.e., deficit spending)
        2. Supply-side economists point to a number of improved conditions.
            a. The increase in manufacturing productivity indicates supply-side economics
                worked.
            b. Comparing saving rates for countries is difficult as different accounting
                procedures are used to measure saving.
            c. When Reagan left office, the average United States citizen earned about 25%
                more than the average citizen of Germany and Japan. 
                1. Data based upon purchasing power parity and not the international exchange
                     rate of the dollar. 
                2. Critics point to a widening income gap between rich and poor.
         3. Other things happened that affected economic activity.
             a. Industry was deregulated. 
             b. Intellectual Property rules were rewritten.
             c. Pressure was put on the Soviet Union by enhancing the military buildup started
                 by President Carter.
             d. Striking air traffic controllers were fired.
             e. Social Security funding was enhanced with benefit cuts and tax increases. 
             f. The government increased dramatically funding semiconductor and network
                 research.
             g. These thoughts are from page H2 of the article by David Warsh in the 
                 February 4, 2001 Boston Globe.

 
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VII.  Recent tax reforms
       
1. Economic Recovery Tax Act of 1981
            a. Cut personal tax rates by 25% over three years
            b. Reduced capital gains tax rate below that paid on ordinary income
            c. Allowed for a more rapid write-off of capital (accelerated
               depreciation)
        2. Tax Reform Act of 1986
            a. Lowered top rates from 50% to 28%
            b. Increased the tax base by doing away with many tax loopholes
        3. Budget Accord of 1990
            a. Increased the top tax rate to 31%.
            b. Increased regressive excise taxes.
        4. Tax Increases of 1990 and 1993
            a. Taxes were increased to lower the deficit.
            b. Hope was a lower deficit would lower interest rates.
            c. Interest rates came down, other things happened to foster a
                strong economy, and the deficit (ignoring the long-term
                social security liability) disappeared. 

         5. Economic Growth and Tax Relief Reconciliation Act of
             2001
and the 2003 

             a. highest income tax rates: the 28, 31, and 36 percent rates
                 fall by 3 percentage points, while the 39.6 percent rate falls
                 to 35 percent.
             b. A new 10 percent tax bracket is carved out of the 15 percent
                 bracket.
             c. Although the cuts in the highest income tax rates phase in 
                slowly, the 0 percent bracket is available immediately.
             d. The tax act also expands the child credit and the Earned
                 Income Tax Credit (EITC)
             e. reduces marriage penalties
             f. increases subsides for education and retirement saving
             g. repeals the limitations on itemized deductions and phase
                 outs of 
                 personal exemptions
             h. provides temporary, limited relief from the alternative 
                 minimum tax (AMT), a complex law that was designed
                 to prevent aggressive tax sheltering but primarily affects
                 large families or residents of states with high income taxes.
             i. The tax act reduces the estate tax and generation-skipping 
                tax between 2001 and 2009 and repeals them in 2010.
             j. Different views of the act
                 1)
2001 Tax Cut takes an in depth look.
                 2) CTJ May 26 Analysis of Final Bush Tax Plan
                 3)
The 2001 Tax Cut Did Make a Difference is what most
                    
conservatives feel 5 years later.
                 4)
Comparing the Kennedy, Reagan and Bush Tax Cuts
                 4) A Comprehensive Assessment of the Bush Administration ...

 6. Jobs and Growth Tax Relief Reconciliation Act of 2003
     
a. Lowered long term (over one year) capital gains taxes from
         20% to 5% for those in the lowest two brackets (Under $65,100
         for married filing jointly in 2008
) and 15% in higher brackets.

    
b.
Most rate reductions would expire if not extended by 2010.
     c.
Primary residence is excluded to $250,000 ($500,000 married
         filing jointly) if held two of the five years prior to the sale.

VIII. The future = Savings + Investment + Risk Taking = Productivity

IX.  Historic Review of government action to stop recessions from the NYT

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