No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Seventeen: A Short History of Macroeconomics 436 a pragmatic technical argument. President Kennedy encapsulated this view in a commencement speech at Yale in 1962: What is at stake in our economic decisions today is not some grandwarfare of rival ideologies which will sweep the country with passion but the practical management of a modern economy. What we need is not labels and clichés but more basic discussion of the sophisticated and technical questions involved in keeping a great economic machinery moving ahead. In this view, demand management could tame the twin terrors of macroeconomics, inflation, and unemployment, without the need of a recession. Macroeconomists thought there was a tradeoff between inflation and unemployment; if unemployment was too high you could reduce it by tolerating a little more inflation (and vice versa). This relationship, known as the Phillips Curve, is seen in Figure 17.2 . The 1960s seemed to bear this out, with slow and steady growth, low unemployment, and low inflation. Yet 1960s spending on both a War on Poverty as well as fighting an actual war in Vietnam ultimately led to real resource pressures, and inflation began rising. In 1968, Chicago economist Milton Friedman presciently showed that there was no long run tradeoff in inflation and unemployment as suggested by the Phillips Curve; attempts to move unemployment below what is considered its “natural” rate would simply lead to higher levels of inflation. Inflationary forces only strengthened with President Nixon’s pressure on the Federal Reserve to ease money supply in front of his 1972 reelection campaign. In the 1970s, demand management fell off the tracks, as prices and unemployment began simultaneously rising. With both stagnation and inflation—“stagflation”—there was no magic Phillips Curve tradeoff. Keynesian economics seemingly had no answer. An alternative to Keynesian demand management is to focus on the supply side of the economy. Supply side economics focuses on the institutions and incentives that lead people to work, save, and invest. In other words, the supply side is concerned with how we get the economy to produce more, not how to consume more (as with AD). After the perceived failure of Keynesian demand side economics to explain the 1970s stagflation, there was a renewed focus on production and a supply side economics renaissance. The Reagan administration made supply side economics the central part of their plan to revive the economy, primarily through reducing marginal tax rates. While a supply side focus is a minority position in economics, almost all economists acknowledge supply side considerations as important, even if they are not the driving factor to halt depression. Figure 17.2, Phillips Curve. The work of economist A.W. Phillips suggested there was a potential tradeoff between inflation and unemployment. If policymakes were willing to accept more inflation, they could reduce unemployment with easier monetary policy, and vice versa. Supply side economics: focuses on the institutions and incentives that lead people to work, save, and invest