What are Neoclassical economics and Reaganomics?

Who are the Neoclassicals?

The Neoclassicals were economists who argued against the Keynesians during the 1960s and 1970s, stating that while demand can be important, the supply side of the economy is still important.  In other words, during the heyday of Keynesian economics, the Neoclassicals (along with the Monetarists) were the minority mainstream macro economists.

How did the Neoclassicals View the world?

They view the macro economy as an aggregated version of microeconomics. In other words, the macro economy is made of many individuals who make decisions that will drive the many forces of the economy.  People want to maximize their utility while firms will want to maximize profit. This means that people will purchase the goods that will maximize their utility given their budget constraints. On the other hand, firms will continue to produce until marginal revenue=marginal cost.

Neoclassicals view all markets as perfectly competitive because it makes the math easier. There are three major tenets of the Neoclassicals (E. Roy Weintraub)

  1. People have rational preferences among outcomes that can be identified and associated with a value.
  2. Individuals maximize utility and firms maximize profits.
  3. People act independently on the basis of full and relevant information.

How did the Neoclassicals explain the determination of GDP?

GDP is determined by an aggregate production function which combines capital, labor, technology, and perhaps other inputs.  For example, when the oil crisis occurred in the 1970s, neoclassical economists explored the effects on the economy by adding “energy” as an input into the aggregate production function.

How did the Neoclassicals explain the supply of Labor and Wages?

Labor supply is based on the birth rate and individuals decisions’ about how much time to allocate to work. Workers will want to maximize their utility, therefore they will work until the marginal utility of one more hour of leisure equals the marginal utility gotten off of one hour’s wages.  Wages are determined through the interaction of labor supply and demand, the latter of which is the marginal product of labor, derived from profit maximization subject to the production function.

How did the Neoclassicals explain the determination of Capital and Investment?

Capital and investment are determined by the interest rate. The higher the interest rate, the lower the investment leading to lower capital. “The assumption of profit maximization implies that the firm will add capital up to the point where the marginal revenue product of the last unit is equal to the cost of using it for one period. (Barry P. Bosworth Tax incentives and Economic Growth, 97)” In other words, firms will replace labor with capital until the marginal product of capital equals the marginal product of labor. The cost of capital is the price of the equipment times the sum of interest and depreciation plus/minus any change in the asset’s value, i.e.

Cost of using asset=(price of asset)(interest rate + depreciation rate +change in value)

(This is the neoclassical cost of capital model we studied in ECON 304.)

How did the Neoclassicals explain the determination of the interest Rate?

There is a pool of savings in which borrowers pull from. If borrowers demand more, or savers save less, then the real interest rate will rise. If savers save more or borrowers demand less, then the real interest rate will fall.

How did the Neoclassicals explain inflation?

In the economy we trade goods and services for goods and services. However a barter economy is very inefficient (How many lawyers represent their local grocer?). This is why we use money, in order to make trade easier.  Inflation occurs when the government prints too much money or when there is more money than there are goods and services to purchase.

How did the Neoclassicals explain unemployment?

Unemployment is a short run phenomenon. In the long run there is no unemployment. In a perfect economy, if an industry were seeing lower demand, then members within that industry would lower wages. The workers would accept these lower wages, or would move to other more profitable industries lowering the supply of labor in the industry and raising wages. However the market isn’t perfect. Workers aren’t willing to accept lower wages; therefore in order to cut costs, firms have to fire workers. When a worker is fired, he/she will be expecting the same, wage he/she was originally earning. If the industry is doing poorly, the worker’s wage expectation has to lower to the new standard before he/she will accept a new job. At the same time, moving to another industry takes time; worker needs to learn a new skill set. This takes time, wherein the worker is unemployed.

According to Neoclassicals, what is the appropriate role of Fiscal and monetary policy?

Because taxes distort economic decision making and cause an inefficient allocation of resources, tax rates should be kept to a minimum, yielding just enough revenue to support essential public expenditures, that is, on national defense and other public and externality goods.  Increasing government spending will crowd out private businesses because government borrowing will increase the interest rate.

Monetary policy should be set at the long run rate of growth of GDP, and should not be used to manipulate aggregate demand.

What is Reaganonomics?

According to Investipedia.com: “A popular term used to refer to the economic policies of Ronald Reagan, the 40th U.S. President (1981–1989), which called for widespread tax cuts, decreased social spending, increased military spending, and the deregulation of domestic markets.”

Proponent of Reaganomics argued that the government should cut taxes, spending, regulation and inflation in order to help the economy prosper.  Since economic decisions are assumed to be based on relative prices and after tax rates of return, there are three key determinants of economic activity:  the after tax return to labor, the after tax return to saving, and the after tax return to investment.

Cutting tax rates should encourage people to work and save more, and businesses to invest more. Cutting spending would cut the deficit, lowering government borrowing; lowering demand on the saving’s pool, lowering interest rates. Fewer regulations mean that it is easier to start and run a business in the US.  Lastly, inflation should be kept under control by tightly controlled monetary policy.

What is the Laffer Curve?

The Laffer Curve is a graphical representation that has the tax rate on the x-axis, and tax revenue on the y axis. At a tax rate of 0%, tax revenue will be 0. At a tax rate of 100%, then nobody will work because the government will take all their income. What this means is that the Laffer curve is a parabola, with the maximum tax revenue corresponding to some tax rate between 0 and 100%. This means that by lowering the tax rate, it may be possible for the government to paradoxically raise tax revenues.  By lowering the tax rate, people will work/invest more (depending on the tax rate) meaning they will be earning more taxable revenue. In other words, the government will be getting a smaller slice of a bigger pie. However this only works if the tax rate is on the right hand side of the maximum.

Were the ideas correct?

Yes and no. The Laffer Curve was correct, however when the Reagan tax cuts were put into place, during the early 1980s, it turned out that that the US was on the left side of the maximum, therefore revenues didn’t go up. However the economy did prosper during these times. Inflation, and unemployment went down, and the economy started to grow. Also while the government was willing to cut taxes, they weren’t willing to cut spending in any meaningful way (see Star Wars, it involved giant lasers in space, I’m talking about Regan’s missile defense system, not the movie).
In general, the evidence on tax rate reductions is mixed. Tax reductions seem to have had no effect on total savings.  Personal income tax reductions seem to have had little or no effect on full time employment, but some of the predicted effect on part time employment or second incomes in a family.  Finally, the evidence for tax rate cuts on investment is strongly supported by the data.

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  49. Sam Jacobs says:

    Thank you for this piece of educative information on Neoclassical. Can you please share the views of Rational Expectation on the following questions. Thank you
    How did the Rational Expectation View the world?
    How did the Rational Expectation explain the determination of GDP?
    How did the Rational Expectation explain the supply of Labor and Wages?
    How did the Rational Expectation explain the determination of Capital and Investment?
    How did the Rational Expectation explain the determination of the interest Rate?
    How did the Rational Expectation explain inflation?
    How did the Rational Expectation explain unemployment?
    According to Rational Expectation, what is the appropriate role of Fiscal and monetary policy?

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