[MUSIC] In the 1980 presidential election, after almost a decade of stagflation, candidate Ronald Reagan ran on a supply side platform that promised to simultaneously cut taxes, increase government tax revenues, and accelerate the rate of economic growth. Without inducing inflation, a very sweet macroeconomic cure indeed. On the surface, the supply side approach looks very similar to the kind of Keynesian tax cut prescribed in the 1960s to stimulate a sluggish economy. However, the supply siders viewed such tax cuts from a very different behavioral perspective. Unlike the Keynesians, they did not agree that such a tax cut would necessarily cause inflation. Instead, the supply siders believed that the American people would actually work much harder and invest much more. If they were allowed to keep more of the fruits of their labor. The end result would be to increase the amount of goods and services our economy could actually produce by pushing out the economy's supply curve. Hence, supply side economics. You can see how supply-side economics offers a very painless way to avoid both the Keynesian stagflation dilemma and the bitter monetarist cure by looking at this figure. After a supply shock, inflation rises, while output and employment falls, but use supply side policies to push the aggregate supply curve back out and voila, the price level falls even as real output and employment is rising. This supply-side philosophy is embodied in one of the few formal theoretical constructs of supply-side economics. The so-called Laffer Curve. This Laffer Curve, named after economist Arthur Laffer, is illustrated in this figure. Where the marginal tax rate is measured on the vertical axis and total tax revenues are measured on the horizontal axis. Note that the Laffer Curve is backward bending, reflecting the behavioral notion that at some point, people will work less the more they are taxed. This backward bend means that above a certain tax rate, m in the figure, an increase in the tax rate will actually cause overall tax revenues to fall. Note also, for a supply side tax cut to actually increase tax revenues, the existing tax rate before the tax cut must be above m. Say, at a rate associated with point n on the curve. This is an important point because, in the early 1980s, the Reagan Administration simply assumed that the economy was, in fact, on the backward bending portion of the Laffer curve. And that a tax cut would increase total tax revenues. Based on this assumption, it moved forward with one of the largest tax cuts in American history. As the corporate tax rate was cut by 25% over three years, the top marginal tax rate on the wealthy fell from 50 to 38%. As part of its Reaganomics program, the administration also cut back sharply on the regulation of everything from monopoly and oligopoly to pollution and product safety, important elements that likewise effect the aggregate supply curve. The next obvious question is, did this supply side experiment work? The answer is a difficult one, and here's what we know. The Reagan years witnessed significant declines in both inflation and interest rates, while we enjoyed a record-long peacetime expansion, and the economy roared back to full employment. Unfortunately, however, as the economy boomed, so too did America's budget deficit. And as the budget deficit soared America's trade deficit soared with it. These so-called twin deficits deeply concerned Reagan's successor, George Bush, particularly after the budget deficit jumped to over $200 billion at the midpoint of his term in 1990. And the economy began to slide into recession. To any red-blooded Keynesian, this onset of recession would have been a clear signal to engage in expansionary policy. However, in the Bush White House, Ronald Reagan's supply side advisers had been supplanted not by Keynesians. But rather by a new breed of macroeconomic thinkers, the so called New Classicals, who had abandoned the old theory of adaptive expectations in favor of a new behavioral model known as rational expectations. We'll talk more about New Classical economics and rational expectations in our lecture on the warring school of macroeconomics. We will also look much more closely at the twin deficits. In the meantime, please remember that economics is not something to be memorized, but rather something to conceptualize. So as you study it, think about it, too. Your job and your business might just depend on it. [MUSIC]
