Macroeconomic Controversies

There are many areas of economics where respected economists may take up contrary opinions. Some of the main macroeconomic controversies include

  • Keynesian vs Monetarist views on managing the economic cycle (role of fiscal policy)
  • Real business cycle theories – the argument the economic cycle comes from supply, not demand.
  • Whether there is a trade-off between unemployment and inflation?
  • Whether tax cuts pay for themselves?
  • Free trade vs protectionism
  • Should the aim of macroeconomics be to maximise economic growth – or should it be other objectives like the environment?

Keynesian vs Monetarist and the role of fiscal policy

Monetarists argue the fiscal policy is ineffective in increasing economic growth. They argue an increase in government spending will essentially crowd out the private sector meaning higher government borrowing only causes higher interest rates and lower private sector spending. Therefore, in an economic downturn, classical economists do not believe there is a role for fiscal policy.

ad-rise-lras-inelastic Classical/Monetarist view on effect of increasing AD.

Keynesian view

However, Keynesians argue fiscal policy can be effective in boosting economic growth when the economy is in recession and in a liquidity trap. They argue, that expansionary fiscal policy does not cause crowding out because the government are utilising unused resources (savings). This is why in recessions, governments can increase borrowing without causing a rise in interest rates.

 

increase-AD-Keyneisan-LRAS-middle

See more: Keynesianism vs Monetarism

Free Trade vs Protectionism

Most economists are united in believing free trade is generally a good policy. Free trade enables countries to benefit from comparative advantage, economies of scale and an increase in economic welfare. Economists point out that even if other countries place tariffs on your exports, the best response for maximising economic welfare is to keep tariffs low and not retaliate.

However, some economists such as (Joseph Stiglitz, Ha-Joon Chan) argue that free trade can lead to a loss of economic welfare for developing economies. They argue that in the development phase there is a good argument for allowing developing countries to have selected tariffs in order to develop new industries and diversify their economy away from concentrating on primary products. Insisting on free trade gives greater benefits to developed economies (and something they didn’t always have themselves)

See Pros and cons of free trade

Tax cuts pay for themselves

Some free-market economists argue that cutting tax rates – income and corporation tax – can lead to an increase in tax revenue and ‘pay for themselves’. The argument is that if tax rates are very high, then it creates a disincentive to work. If taxes are cut, workers have more incentive to work, and firms have more incentive to invest. Therefore, tax cuts can spur economic growth – leading to higher tax revenues.

laffer-curve-2018 The Laffer curve showing how in theory a tax cut can boost tax revenues.

However, other economists are very sceptical, unless tax rates are very high to begin with.

Evidence from 2017 US tax cuts showed cutting tax for high earners and corporations led to a fall in tax revenue and a rise in the US budget deficit of £300bn per year. (US 2017 tax cuts)

Free market vs government regulation

Some economists argue that the free market generally provides the optimal format for resource allocation. They argue leaving decisions to the free market will lead to the best outcome. Therefore, these economists stress the role of privatisation, deregulation and removal of government regulation. However, others are more critical of free-market arguing the free market can lead to boom and busts in asset markets. In other words, agents are not always rational and the market can fail to adequately price risk. The recent credit crisis is an example of how markets can fail.

  • Austrian Economics is often held up as an ideological justification of this free-market approach.

What is the aim of macroeconomics?

Traditionally macroeconomics has been concerned with increasing real GDP and maximising the rate of economic growth.

However, with increased concerns over environmental issues, many are concerned that rising GDP may not actually be increasing living standards. Some economists a much wider range of variables needs to be considered for judging economic welfare. (Does increased GDP increase living standards?)

Inflation vs Unemployment

There is also a debate about whether there is a trade-off between inflation and unemployment.

phillips-curve-arrow

The Phillips curve suggests there is. This is related to the Keynesian view of economy – boosting AD can increase economic growth, with some inflation.

However, monetarists argue there is no trade-off in the long-term. Increasing AD only causes a rise in nominal GDP and not real GDP.

phillips-curve-breakdown

In the 1950s and 1960s, there was evidence of a trade-off, but in the 1970s, there was a breakdown in the Phillips Curve. Some economists, like Milton Friedman, claim this shows there is no trade-off. Other economists claim there was still a trade-off but it was now a worse trade-off.

There is debate about how rigidly to stick to inflation targets. For example, the ECB generally is stricter in keeping inflation low. The Bank of England has adopted a more flexible approach to temporary cost-push inflation.

The ECB target is keeping inflation less than 2%

The Bank of England target is keeping inflation at 2% +/-1, plus maintaining reasonable economic growth.

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