Did Reaganomics Work - Essay Example

?Q1: Did Reagonomics work? Reagonomics refers to the economic policies implemented by President Reagan during his term from January 1981 to January 1989. According to William A. Niskanen, one of the members of President Reagan's Council of Economic Advisers, the policy had 4 key pillars upon which it was based: 1) a restrictive monetary policy designed to stabilize thevalue of the dollar and end runaway inflation 2) a 25 percent across-the-board tax cut enacted (The Economic Recovery Tax Act of 1981) designed to spur savings, investment, work, and economic efficiency 3) a promise to balance the budget through domestic spending restraint 4) an agenda to roll back government regulation. These policy changes were expected to increase saving and investment, increase economic growth, balance the budget, restore healthy financial markets, and reduce inflation and interest rates. As a result of these economic decisions, during President Reagan’s term, the real GDP growth was observed at 3.2% compared which was higher than both pre and post-Reagan era. The unemployment rate reached a minimum of 5.5% from 7.5% at the start of term of President Reagan. The real median income for families increased to nearly $41,000 at the end of term; this was significantly higher than 10 years before and 10 years after President Reagan’s term. Inflation touched a minimum of 2% in 1986 and ended at 5% in 1989 compared to 11% at start of term in 1981. The growth of government spending was 1% during president Reagan’s term compared to 3.5% before him and 4.5% after him. Real income tax revenues increased by 16.3% even after top income tax rate had been reduced from 70% to 50% in 1983 and to 28% in 1986. The nominal federal revenues increased from $517 billion in 1981 to $1.031 trillion in 1989. On the downside, however, Reaganomics was used when US was at peace at the time, yet the national debt increased from 26.3% of GDP in 1981 to 42.3% in 1989. Secondly, the savings rate fell from 8% to 6.5% during president Reagan’s term as a result of his economic policies. Thirdly, the rich got even richer and the poor got even poorer. Reaganomics largely believed that if more wealth was given to the rich, they would re-invest this money, which did not really happen. Given the positive and the negative outcomes of Reaganomics, it can be said that while Reaganomics did work well for the years it was in force, it wasn’t a very sustainable economic policy as it relied mainly on increasing national debt to cover for the economic growth. Q2: Show graphically the effects on macro economy of a sharp rise in OPEC oil prices in a. the short run. b. the long run. How do you account for the differences in your answers to parts a and b? A sharp increase in OPEC oil prices occurs due to a supply shock that is a sudden drop in supply of oil. Below figures show its effects in the short and long-run. Short-run effect of a sharp increase in oil price is illustrated in figure 1 below: Figure 1. Short-run effect of Sharp increase in oil prices In the short-run, the supply shock causes price levels to increase due to inflation caused by high oil prices not only on oil dependant industries but also on transportation of goods and services. This leads to a drop in total output as well as price levels have increased but the wages have not in the short-run – leading to stagflation. Thus, the short-run effect is an increase in price levels and a decrease in total output. Figure 2. Long-run effect of a sharp increase in oil prices Due to increase in inflation in the short-run, unemployment starts to increase. Wages start to decrease. This leads companies to start hiring people. Also, the short-run effects bring about economic policy changes by the governments that are targeted to increase the output and to reduce inflation – which could be an increased government spending and/or decrease in interest rate. As the inflation comes under control, the real wages start to increase. This leads to an increase in demand in the long-run and the net effect is that the output returns back to where it was pre-supply shock but at higher price levels. Thus, the long-run effect is an increase in price level and no change in total output. Q3: 3. Contrast rational expectations and adaptive expectations views of the Phillips Curve According to the adaptive expectations theory, people believe the best indicator for future is the present information. Thus a response to the economic policy changes occurs in two stages – a short-run change and a long-run change. Whereas under rational expectations theory, people are smart enough to foresee that would be government’s response to the present economic situation and are able to adjust their response in advance. Thus according to the adaptive expectations theory, expansionary monetary and fiscal policies to reduce unemployment are useless in the long-run because after a short-run reduction in unemployment, the economy will self-correct to the natural rate of unemployment, but at a higher inflation rate. According to the rational expectations theory however, systematic and predictable macroeconomic policies can be negated when businesses and workers anticipate the effects of these policies such that people acting on their expectations of predictable expansionary policies can cause inflation. Figure 3. The adaptive expectations theory view on Philips curve Imagine the economy operating at NAIRU and at PC1 (Philip curve 1). According to the adaptive expectations theory, as the aggregate demand increases due to government policy, in the short-run it causes inflation rate rise, real wages fall and profits to rise. As a result, unemployment rate falls. However, now in long-run, people adjust to this new higher inflation rate and demand higher salaries so the nominal wages increase and profits fall and the unemployment rate is restored to NAIRU. The Philips curve shifts up to PC2. Now the new inflation rate becomes the reference and the Philips curve keeps shifting up until it reaches the long run PC which is at the same unemployment level as at the beginning. Figure 4. The rational expectations theory view on Philips curve. According to the adaptive expectations theory, as the aggregate demand increases due to government policy, the inflation rate rises and the nominal wages adjust quickly to inflation rate. Thus the inflation rate rises on vertical line at full employment. In short, the long-run is now. References Niskanen, William A. Reagonomics. The concise encyclopedia of economics. Accessed 19 June 2011. http://www.econlib.org/library/Enc1/Reaganomics.html#abouttheauthor Niskanen William A. Moore, Stephen. October 1996. Supply-Side Tax Cuts and the Truth about the Reagan Economic Record. Cato Institute Policy Analysis No. 261. Accessed 19 June 2011. Available at: http://www.cato.org/pub_display.php?pub_id=1120 Pajholden. 2008. Philips curve. Video uploaded on YouTube. Accessed 20 June 2011. http://www.youtube.com/watch?v=-Fk_2iRfC18 Read More