Question

2.

KEYNESIAN AND SUPPLY-SIDE ECONOMICS

Keynesian and Supply-Side Economics are two competing macroeconomic approaches to correcting an economy that is experiencing a recessionary gap.

1. Summarize the two schools of macroeconomic theory.

2. What is the primary difference between the two approaches.

3. Summarize the primary criticisms of each approach.

4. The Reagan administration used supply-side economics to “right” the economy in the early 1980s—explain why that approach was better than a Keynesian approach given that the economy was suffering from stagflation.

Answer 1

1. The Keynesian economics or the school of thought was propounded by the globally renowned British economist John Maynard Keynes during the aftermath of the Great Depression of late 1920s. The Keynesian economics is ideally based on the notion that any recessionary effect in the economy or economic downturn can be subsequently rectified by stimulating the aggregate demand or AD in the goods market or the economy through proper and adequate government intervention. Now, in this regard as proposed by Keynes, the government can increase its administrative expenditure and reduce the taxes in the economy to stimulate the AD leading to higher aggregate output and economic growth or stability. Therefore, summarily it can stated that the fundamental essence of the Keynsian economics is based on stimulating AD through viable and adequate government or administrative intervention in the economy as a means to achieve sustainable economic recovery or growth during any recession or economic downturn or slowdown which essentially makes it a "demand-side" economic theory.

The supply side economics or popularly known as Reaganomics was mainly espoused by the 40th president of the United States, Ronald Reagan. The supply side economic theory is fundamentally based on the idea that higher tax reduction or cut for business or capital investors, private businesses, and entrepreneurs can eventually stimulate economic growth and stability in the long-run. A tax cut or reduction for businesses, investors, and entrepreneurs and other favorable regulatory business policies can consequently induce higher production of goods and services in the economy which would expectedly lead to higher mobilization and utilization of various productive resources or factors or inputs of production leading to higher resource or factor employment as well. Hence, inducing higher production of goods and services through business tax cut or reduction is the main key to achieve sustainable economic growth or stability on the basis of the supply side economics implying that basically the supply side of the economy is the cardinal deterministic factor behind economic growth and progress.

2. Based on the main theoretical premise or essence of both the Keynesian economics and supply side economic theory the chief difference between the two theories basically lies in the remedial approach advocated by both theories to rectify any recessionary impact or economic slowdown or downturn. The Keynesian view predominantly highlights the importance of the aggregate demand in stimulating economic growth amidst recessionary phase or period by inducing overall consumer demand for good and services through a tax cut by the government thereby raising the disposable income of the individuals and households in the economy and increasing government expenditure/purchase which would consequently raise the government or administrative demand forgoods and services as well. As the consumer demand and the administrative or government demand for goods and services expands in the economy the aggregate consumption expenditure on various goods and services in the economy would also rise leading to an increase in the aggregate demand. An increase in the consumer demand for goods and services would further induce the firms and the companies to increase the production of various goods and services leading to higher business or capital investment and increased employment and utilization of productive resources or various factor inputs in the economy. Hence, an increase in the consumer demand for goods and services can induce higher aggregate demand and production of good and services thereby causing an increase in the aggregate output level in the economy and ensure economic growth and stability in the process.

On the other hand, the supply side economics mainly emphasizes on the supply-side of the economy as the cardinal deterministic attribute behind sustainable economic growth and stability during any economic downturn or slowdown. As advocated by the supply side theory, various business and investment tax cuts and other favorable regulatory policies would benefit the individual businesses, capital or business investors, and new business owners and entrepreneurs to gradually increase investment on various business or commercial projects and undertakings and operational activities thereby leading to an increase in the overall production of goods and services in the economy. This would also induce higher resource or factor mobilization or utilization by the business organizations or companies leading to higher employment in the labor market and the domestic economy. Hence in constrast to the Keynesian view, effective mobilization of the supply side of the economy or an increase in the production level of goods and services is the main key to stimulate a sustainable economic growth in the long-run considering its positive impact on enhancing the aggregate output and the employment level in the economy.

3. As practically conceived by many economists, one of the major problems associated with the application of Keynesian theory includes the risk of prolonged and sustained budget deficit for the government due to a consistent expansionary fiscal policy. As the government increases government expenditure or purchase and reduces taxes, it would consistently reduce the tax or government revenue and increase the government sending thereby creating a prolonged budget deficit. Furthermore, a consistent or expanding budget deficit entails higher financial borrowings by the government to finance the deficit which entails an increase in the interest rate on financial bonds thereby discouraging business or capital investment by the private firms or companies. A consistent expansionary fiscal policy or an increase in government expenditure and a simultaneous reduction or cut in taxes to enhance aggregate demand holding the aggregate supply of goods and service constant could also cause a prolonged inflationary effects or rise in the price level of goods and services in the economy. Additionally, it is also highly imperative to increase the overall production of goods and services in the economy to compensate for an increase in the aggregate demand through expansionary fiscal policy under the Keynesian perspective. If the supply side of the economy cannot be stimulated sufficiently by impleiing higher productivity in accordance with the increase in aggregate demand, it could potentially led to output gap and a sustained inflation in the economy. As observed by Milton Friedman, one of the most prominent and active critics of Keynesian economics, a consistent and sustained increase in government spending and tax reduction even after the recessionary period in the economy can subsequently lead to higher taxes and spending regimes. Therefore, the expansionary fiscal policy to stimulate aggregate demand has to be short-term and temporary based on the severity of the recession or economic downturn.

The critics of the supply side economic theory argue that even though relevanttax cuts and various favorable business regulatory policies by the government can stimulate the production of goods and services but it would take a substantially long time as adjustments of production methods and mechanisms and the improvement of the productivity and efficiency of the resources and factors or inputs of production would practically take a considerable amount of time. Furthermore, the practical implementation and effectiveness of the supply side economics involve additional administrative or government costs or expenses as the government has to additionally invest in various infrastructural facilities and resources and other commercial incentives to facilitate the operational functioning and production of the firms or companies. One of the major objectives of the supply side economic policies is to encourage the new businesses to enter various markets or industries which would contribute to the increase in the overall production level of goods and services but however, it would also take a long time for new businesses to properly set up and begin their regular operational and production activities. The supply side policies are also believed by many economists to have an inequitable impact of the income distribution of any country especially in the short-run as tax reactions can lower the power of labor or worker unions and increased privatization as a result of the supply side policies might lead to a widening income gap between the rich and poor section of the population.

4. In Macroeconomics, stagflation is basically described as a situation characterized by inflation or rise in the price level of goods and services and a simultanous stagnancy in the aggregate output which essentially contradicts the Keynesian notion that inflation or increase in price level of goods and services is associated with higher output level and employment which is primarily impelled or driven by a rise in aggregate demand. Therefore, in stagflation, increasing aggregate output level by stimulating aggregate demand can further increase the risk of further inflation. Hence, in such circumstances supply side policies can be relatively more effective than the Keynesian theory or recommendations as stimulating the supply side of the economy or the production level of goods and services by the private firms, companies, and businesses through investment/business tax cuts and favorable business and regulatory policies by the government can stabilize or alleviate the inflationary impacts in the goods market and the economy, holding aggregate demand constant. An increase in the production level of goods and services by firms would increase the aggregate supply in the goods market and considering aggregate as constant, this can lead control or stabilize any further increase in the price level of goods and services and increase the equilibrium aggregate output level in the goods market and the economy.