Keynesian, monetarist and supply-side policie

Keynesian, monetarist and supply-side policies: an old debate gets new life
by M. Niederjohn Scott, William C. Wood

Debates over how to promote a healthy economy are pervasive once more, after decades when it seemed such debates had been put to rest. The market meltdown of 2008 ended a long string of years in which monetary policy reigned supreme. Monetary policy is the regulation of money and the banking system to influence economic variables. Its adherents, the "monetarists," had faced little challenge as they de-emphasized the role of fiscal policy, defined as the control of taxes and spending to influence economic variables.
Activist use of fiscal policy was inspired by the work of British economist John Maynard Keynes. Keynesian fiscal policy--out of fashion with economists and policymakers for decades--has enjoyed a stunning revival under President Obama's new economic policy team. The size of the stimulus package started at $825 billion, even before congressional add-ons. The final package, after debate and compromise, included a mix of spending on energy, infrastructure, health care, tax cuts, and direct payments to the unemployed and disadvantaged.
The Keynesian theory is simple. Keynes taught that economic downturns are caused by inadequate total demand ("aggregate demand"). His prescription to solve this economic affliction was for government to provide the demand that the private sector wouldn't, even if that required deficit spending. Recent discussions, covered extensively in the media, have focused on the infrastructure spending component of Obama's plan--such policy is right out of the renowned Great Depression-era economist's playbook.
The monetarist theory is also simple. Its intellectual father, eminent economist Milton Friedman, argued that properly regulating the supply of money and the banking system would allow the economy to cure itself when recession set in. His primary case in point was the Great Depression, when a shrinking money supply and bank failures made an economic downturn into a national disaster.
Friedman argued that the Federal Reserve could have stopped the Great Depression by providing banks with more liquidity and stopping the money supply from falling. In fact, Ben Bernanke, the Federal Reserve chairman today, apologized to Friedman in a famous declaration, saying: "You're right. We did it. We're very sorry. But thanks to you, we won't do it again." (1) Indeed, Bernanke's Fed has been supplying liquidity to the banking system in record amounts. The monetarist prescription sees this liquidity as promoting lending, lower interest rates and greater aggregate demand. Unfortunately, the economy has not quickly responded. Unlike the Great Depression--liquidity is not the problem this time. The Federal Reserve's unprecedented actions have assured that banks have plenty of money; they just aren't lending it out, Aggregate demand has remained anemic.
Even as Keynesians and monetarists have debated how to increase aggregate demand, supply-side economists and their political allies have been insisting that demand is typically not the problem. They believe that conventional policies increasing spending will only give small upward bumps to the economy. Their cure, therefore, is tax cuts designed to increase productivity, entrepreneurship, and risk-taking. The resulting increase in aggregate supply, they believe, will lead to economic recovery.
To supply-siders, not all tax cuts are equally good. They place their emphasis on the "marginal tax rate," the percentage taxed away from an extra dollar of income earned. A marginal tax rate of 40 percent, for example, would mean that 40 cents of each additional dollar of income would be taxed away, leaving an after-tax reward of 60 cents for the person who earned the dollar. High marginal tax rates kill economic initiative, they believe, and tax cuts that leave marginal tax rates high are useless. As an example, a fixed $500 tax credit to everyone would not affect the after-tax reward of earning an additional dollar of income. It would leave marginal tax rates unaffected and therefore would have no direct effect on promoting aggregate supply.

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