Reagan’s Tax Cuts and the Volcker Recession

(Dan here…lifted from Robert’s Stochastic Thoughts)

Reagan’s Tax Cuts and the Volcker Recession

 Max Boot is a candidate member of the Rubin Gerson can’t be a conservative anymore, because I always agree with them club of Washington Post columnists. But he is a bit confused about US macroeconmic history and macroeconomics. He wrote”The deficit spending of the Reagan years was at least justified because it boosted the economy out of a deep recession “

As a matter of timing, this can’t be right. The Kemp Roth tax cut was enacted in 1981. Real GDP peaked in 1981q3 — the tax cut corresponds to the beginning of the recession not the end.

The part that Boot misses (because it has been unimportant for the past 10 years) is monetary policy. It is possible to cause a severe recession in spite of fiscal stimulus by driving the Federal Funds rate up over 19 %. The combination of loose fiscal and very tight monetary policy caused huge real interest rates and a collapse of investment. It also caused an over-valued dollar, a huge surge in imports and deindustrialization.

One can discuss the effects of fiscal policy without considering the response of monetary authorities only when monetary policy is constrained by the zero lower bound. If GDP is determined by the Fed’s ideas about what level is consistent with low inflation, then fiscal policy which is, in itself, stimulatory just changes the composition and not the level of demand.

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