Supply Side Economics on Tax Cuts International Transmission of National Economic Shocks Impacts of an Appreciating Economy

1. Monetary and Fiscal Policy
Group Assignment
Group 4
Members:
Prajakta Talathi
Manoj Megotia
Krishnamurthy Sripathy
Abhinav Chaudhary
Gautam Sachdev

2. Proponents’ Views to Supply Side of Economics
1. Introduction – Lowering hurdles for
people to produce (supply) goods and services,
incentivize people to produce more goods and
services. Removal of such hurdles broadly
includes tax cuts and reducing regulations.
2. Concept – Requirement of tax cuts at
different times during growth of an economy can
be explained with the help of Laffer curve.
Whenever taxes in the economy are on right of
(TRmax), there is a requirement of tax cuts for
different skew-ness of Laffer curve. It is pertinent
to note that Laffer curve is not symmetrical for
all income earning people of an economy. Rich /
very rich people may have R max (Maximum
Revenue) at more than 50% of tax rate, while low
earning groups may have R max only at 8-10%.
3. Tax cuts shifts aggregate supply curve to
right due to following reasons –
Opponents’ Views to Supply Side of Economics
1. Introduction – Lowering taxes reduces
revenue of the government and subsequently
increased budget deficit, increased borrowings
and thereby decreased overall growth and
increased unemployment.
2. Concept – Reducing taxes increases
supply of money in economy that cause
inflation. Although suppliers and consumers
have more money, they are not able to produce
or consume more because of inflation. This
means no stimulus to economy.
3. When the government pursues an
expansionary fiscal policy, government's
spending increases or tax rates decreases, which
drive up interest rates. Higher interest rates in
conjunction with increased government
spending tends a crowding-out effect. From
multiplier effect we can deduce that the tax cuts
doesn’t grow economy as much as alone
government spending:
From IS-LM curve
∆Y/∆G = 1/ (1-MPC) and ∆Y/∆T = -MPC/ (1-MPC)
Question 1: Supply Side Economics on Tax Cuts

3. (a) Tax cuts encourage business and
individuals to be more honest about
earnings, rather than hiding earnings.
(b) Low taxes encourage businesses
and individuals to move money from
lower productivity tax-free investments
to more taxable investments.
3. Effects of tax cuts – US economy
witnessed the major positive impacts of
implementing supply side economics during
Presidency of Ronald Reagan and George .W.
Bush. From 2003 to 2007, reduction in taxes saw
a 44% increase in Federal tax revenues from
$1.782 trillion to 2.568 trillion. Collection in taxes
has been despite of tax cuts. The answer lies in
the graph below –
If the same growth were to be tried to
achieved through demand side of
economics, it would have resulted in
meagre increase in GDP and
disproportionate increase in prices.
a) Assuming MPC = 0.6.
b) Considering a tax cut of 10 billion and
increased government spending by 10 billion.
∆Y/∆T = 0.6 / (1- 0.6) = 0.6 / 0.4 = 1.5
∆Y/∆G = 1 / (1-0.6) = 2.5
Thus, a ∆T of 10 billion, has a net effect of $ 15
billion, whereas a ∆G of 10 billion has a net
effect of 25 billion on the economy. So clearly,
the aim of fiscal policies should not be to reduce
taxes but to increase govt spending, which may
be even at cost of increased taxes.
3. Effects of tax cuts – Application of
supply side of economics resulted in its worst
effects during George .W. Bush era. Few
statistics throw enough light on the ill-effects of
supply side of economics. These are as
enumerated below –
(a) Budget Deficit for US
government shifted from a surplus of
$128 billion in FY2001 to deficit of $158
in FY 2002 by implementation of supply
side economics jargon and by 2009
deficits increased to an all-time high of
$1413 billion.
(b) Debts on US economy during tax

4. 4. Supply side economics impacts on US
economy during Bush tax should be reviewed to
understand that why, ‘Tax cuts pay for
themselves’. Federal revenues in FY2003 were
$1.665 trillion, $360 billion lower than in FY2000.
Federal revenues in FY2004 were 1.707 trillion,
$318 billion lower than in FY2000, but by 2006
revenue had completely recovered (in inflation
adjusted dollars), with receipts at $2.037 trillion,
$12 billion higher than 2000. The cumulative
total of federal revenues less than in FY2000 for
the fiscal years 2001-2005 was $1.142 trillion,
with that amount expected to be recovered by
2011, with 2012 expected to produce an
additional $400 billion in excess revenue over
2000. Last but not the least during these tax cuts
the US GDP increased from $10.987 trillion to
cuts rose from $6500 billion in FY 2003
to $10400 billion in FY 2009.
(c) The real GDP growth from 2001
to 2007 was only an average of 2.7 %
against an average of 4%.
(d) On a longer term, supply side
economists also suggested that that
overall benefit of tax cuts will be shown
by 2012, however CBO recently
concluded that Bush tax cuts reduced
federal revenues by $2.8 trillion
between 2002 and 2011.
4. Conclusion – Neither from perspective
of GDP growth, nor from deficits and debts
control, it can be deduced that tax cuts were an
ideal move during Reagan and Bush Presidency
time.

5. $14.074 trillion, which clearly shows that growth
of an economy can be achieved by tax cuts.
5. Conclusion – Summarily, supply side
economics may have not given concrete statistics
on all the fronts, but discounting for Vietnam
War recovery during Reagan Presidency time,
compelling social security spending during
Reagan and Bush time, still tax cuts proved
correct on Laffer curve. Federal tax revenues
indeed went up. Also, for true implications of
supply side economics one has to wait and
watch, when in holistic manner tax cuts will be
applied with cuts on government spending and
deregulation of avoidable government
regulations.
Considering even the Laffer curve to be true, we can’t outright reject the hypotheses that
then equilibrium point (during tax cuts) on the Laffer were not on Right of T Rmax but on left of it
and at that time the requirement was of tax increases. However, it remains to doubt that even
supply side economics exists or not as called by George .H.W. Bush is it truly ‘Voodoo Economics’?
Sources: Investopedia.com
Forbes.com
Wikipedia.com
FT.com
Thefiscaltimes.com

6. In an open economy National Income Identity Equation is:
The National Income Identity equation shows that an economy’s net exports must always
equal the difference between its saving and its investment.
Question 2: International Transmission of National Economic Shocks
The current financial crisis is remarkable in many ways, but one aspect is of special interest for
international economists. International economists have been interested in interdependence for a
very long time – arguably too interested. Global interdependence is one of those topics people
love to talk about because it sounds sophisticated.
But the interdependence this time is real – and it seems to be operating through channels that are
not yet part of standard international macro analysis. Much thinking about international linkages
still relies on some version of the traditional foreign trade multiplier: country A’s GDP affects its
level of imports, which are country B’s exports, so demand shocks get transmitted through
international trade.
2a
•Using the National Income Identity in a two country framework, show how the deficit in the current
account of a country (say US) is linked to the surplus in another country’s (the rest of the world)
current account.
Y = C + I + G + NX
Rearranging,
(Y – C – G) – I = NX
But,
Y – C – G = S
Therefore,
S − I = NX
Where,
Y = GDP or Output
C = Consumptions
I = Investments
G = Government Expenditure
NX = Net Exports
S = Savings

7. When exports of the domestic country rise, the imports of the foreign country also rise. As
the exports of the domestic country rise it leads to an increase in export earnings and thereby
creates a current account surplus. As the imports of the foreign country rise it will lead to fall in the
income of the foreign country thereby creating current account deficit. As its income falls, its
imports will also fall which will have its repercussion on the exporting country i.e. on the domestic
country.
Consider the US having low savings, S and substantially high investment, I. Now if the US
runs into a deficit (BDEF>0), then the only way to sustain this situation is if it runs into a foreign
trade (current account) deficit (X–M<0). In Japan, on the other hand, (S>I) which offsets any budget
deficit (G+T>0). Given these domestic imbalances, Japan will run a trade (current account) surplus.
Thus, the current accounts of an exporting country and an importing country are interrelated.
Current Account Balance = Trade Balance + Income Balance + Net Unilateral Transfers
Where,
Trade Balance = Merchandise Trade Balance + Services Balance
Y = C + I + G + NX
(S - I) = (NFP - TDEF) + BDEF
Where,
NFM is Net Foreign Payments
Trade Deficit, TDEF = M – X
Budget Deficit, BDEF = G – T

8. The Foreign Trade Multiplier brings about the effect of change in exports on change in
income. Exports in the open economy are exogenous; they do not depend upon the national income
of an economy but get determined in the external factors like taste and preferences of the residents
of the foreign country and the national income of the foreign countries. Imports get determined by
national income of an economy and so are indigenous.
The equilibrium level of National Income gets established when savings are equal to
investment and imports are equal to exports.
Assuming G = 0, the equilibrium takes place when,
After introducing the change,
2b
•Then using the same identity show how the national income in one country is linked to that in
another country (you need to employ the so called “foreign trade multiplier” expression.) In this
context, illustrate how a drop in demand for imports (say due to a downturn) in one country will
drive the GDP in both economies lower.
M = f(Y)
Savings = Investments
(S = I)
and
Imports = Exports
(M = X)
The equilibrium condition is:
Y = C + I + G + X – M
I + X = S + M
▲S + ▲M = ▲I + ▲S

9. The marginal propensity to saving i.e. ▲S/▲Y determines change in savings(S) while the
marginal propensity to import determines the change in imports (M) hence the equation will be:
The Foreign Trade Multiplier, Kf, is a function of marginal propensity to save and to import.
There is an inverse relationship between S+M and Kf.
Hence using Foreign Trade Multiplier the formula of income propagation is:
Consider there are two countries taking part in the foreign trade; suppose due to an
economic downturn the imports of the target country go down, consequently the exports of the
exporting country will also go down. The Foreign Trade Multiplier of the exporting country will go
down, this is called Foreign Repercussion. Hence net exports will go down, and consequently the
income/GDP of the country will go down. In other words, Home country GDP affects Foreign GDP
through its effect on imports: higher Y leads to higher home imports and therefore higher foreign
exports, hence higher Y*. And Y* affects Y in the same way. A negative demand shock in Home
country would shift HH to the left, thereby inducing a series of reactions that would reduce both
Home and Foreign GDP
(S + M)▲Y = ▲I +▲X
Kf = f (S + M)
▲Y = (▲I + ▲X) / (MPS + MPM))

10. Identifying a solution requires a comprehensive understanding of the causes that lead to the
problem. The foreign trade multiplier ceases to fully explain the current macroeconomic
interdependence between world economies, partly because of the following:
a) Unlike in the past, presently there are large international cross holding of assets i.e. a
complicated web of receipts and payments link the balance sheets of a wide variety of
intermediaries, such as hedge funds and banks, into a global financial network. Sophisticated
financial products, such as credit default swaps and collateralized debt obligations, have
complicated the financial regulation. e.g. USA assets abroad in 2007 accounted for about
42% of ROW GDP. While foreign assets in USA were as much as 50% of ROW GDP exposing
the economy to financial contagion.
b) Speculation and excessive herding behaviour by the investors, credit cutting by hedge funds
in times of crisis are the pressure points that clouded the macroeconomic situation in the
past.
The answer to the problem is the replacement of the traditional trade multiplier with the
International Financial multiplier. The core problem is capital and not liquidity. An appropriate
injection of capital, such as issuing of treasury bills cannot undo the effects of Traditional Trade
Multiplier but can undo the Financial Multiplier effect of that shock.
2c
•) The fact however is that in spite of globalization, trade flows don’t seem large enough
to produce all that much interdependence. For instance, U.S. imports of goods and
services as a percentage of rest-of-world GDP since 1980 has roughly doubled, but it’s
still fairly small. One way to think about this is to ask what it would take for a U.S.
recession to impose a one percent of GDP negative demand shock on the rest of the
world. For this to happen, U.S. imports would have to decline from 6 to 5 (percent of
rest of the world GDP) – a 17% decline. Given that the typical estimate of the income
demand for imports is around 2; this would require a decline of more than 8% in U.S.
GDP. So it would take an extremely severe recession in the United States to produce
even a moderate-sized negative demand shock abroad. In light of this, we need to look
elsewhere to explain the observed interdependencies of the late. Discuss what in your
opinion should replace the old international trade- multiplier model to explain the
current international linkages. Support your answer.

11. Improving an economy’s liquidity and limiting its exposure to contagion require a sound
domestic financial regulation structure. An understanding of financial contagion between financial
intermediaries, such as banking, rating agencies and hedge fund will be conducive to making
financial reforms. Also by set up the capital ratio to jungle the balance between maximizing banks'
profit and shielding them from shocks and contagions.

12. South Korean WON is one of the perfect examples to warrant the given study of a currency
whose appreciation has affected the economy in both negative and positive manner. South Korean
WON has been on a rising trend in the past few years.
Source: Investopedia.com
The won last month, trading at around 1,060 to the USD has strengthened to around 1,054,
its strongest level in more than two years. Badly hit by the financial crisis in 2009 with growth rate of
0.9% from 2.3% in 2008, South Korea has shown a steady increase in the growth rate with close to
6.0% in 2010. The currency has been boosted by strong foreign demand for South Korean stocks and
bonds exports, which account for 53% of its GDP. This has made Korea gained a safe-haven status
amid the recent turmoil in emerging markets.
B. Although a stronger Won's impact on Seoul's exports have become less sensitive compared
with the past, South Korean policymakers are increasingly wary of the local currency's steady
appreciation against the USD as the stronger won is feared to dampen the recovery momentum of
Asia's fourth-largest economy. But compared with the past, such negative impacts have eased on
the local economy due to several factors like changes in industrial structures.
Question 3 : Impacts of an Appreciating Economy

13. How making winners – Though exports account for about 50% of the Korean economy,
Korea has increasingly imported capital goods as intermediary for overseas shipments. As of 2012,
imports of consumer goods accounted for 7.5% of consumer spending and government spending, up
from 3.9% in 1995. South Korea's currency reserves hit a record high in September in what analysts
say is a clear sign that Seoul is determined to prevent a sharp appreciation of the won and build up
its fire power to offset the impact of any tapering by the Federal Reserve.
How making losers - A stronger Won generally erodes the price competitiveness of exports
as it makes prices of Korean goods more expensive in overseas markets. The Won's appreciation to
the dollar negatively affects the Korean economy. On the other hand, In the case of South Korea
pursuit of a weaker Won may not necessarily be good. The report by the Woori Finance Research
Institute showed that usually the Won's gain dents Seoul's exports, but because imports of capital
and consumer goods increase, the Won's strength reduces the value of expenses, increasing the real
purchasing power.
Future Remedies - The government should step up efforts to stem volatile foreign capital
inflows including additional macro-prudential measures while keeping watch of possible reversal of
capital inflows. Since 2010, South Korea has implemented three measures to curb excessive foreign
capital flows, including regulations on banks' foreign exchange forward positions and levies on
banks' non-core foreign liabilities.
C. Industries that Benefit from High Currency Value
1) AutomobileIndustry– The automobile industry is one industry that truly benefits out of
rising currency value. Rising value of the domestic currency brings down the oil prices as
more oil can be imported in the same value. Lowering down of the oil prices definitely helps
in boosting the sales. The sales of Korean car manufacturer Hyundai went up by 8%, selling
close to 66,000 units.
2) Information and Telecommunication Industry–As this industry is majorly dependent on
outsourced projects, a higher value of the domestic currency ensures higher financial

14. returns for the same output. The Korean IT giant Samsung reported increase in yearly
revenue by 18.92% due to rise in the currency value.
3) Mining Industry – Most of the required mineral ores are found in Korea but not in
abundance due to which South Korea has to import majority of its mineral ores including
coal and iron ore. A high currency value brings down the price import prices.
Industries that Lose from High Currency Value
1) Export Food Industry –The export food industry loses with the rise in the prices if the
domestic currency. The main reason for the sameis the highly competitive market scenario
in which the rising prices to import from one region forces the buyer to look for other
cheaper alternatives.
2) Overseas Education – Overseas Education is one sector that particularly loses out of rise in
foreign currency. Students going abroad for further studies have to shell out more amount
of money due to rise in the currency prices. One of the examples is of Sungkyunkwan
University.
3) Defense Industry – Located in the most heavily militarized area, South Korea is major
manufacturer of arms, ammunition and military equipment. Any upward fluctuation in the
value of the domestic currency brings down the overall defense exports by making tentative
clients look for other cheaper options available. An ideal example on such effect is for
Hyundai and Samsung.

15. References:
http://www.mu.ac.in/myweb_test/M.Com.%20Study%20Material/M.Com.%20-%20I%20-
%20Eco.%20of%20Global%20Trade%20&%20Finance.pdf
http://www.princeton.edu/~pkrugman/finmult.pdf
http://economistsview.typepad.com/economistsview/2008/10/krugman-the-int.html
Mankiw - Macroeconomics
Pre-learning material of SP Jain GMBA
Wikipedia
http://english.yonhapnews.co.kr/business/2013/10/24/68/0503000000AEN20131024003600320F.h
tml