Obama economic theory

Name

11/13/11

Assignment 7: Paper 2

The article is from Bloomberg Business week for the week of November 14 to November 20, 2011 the title is called Nudge Not. This article explains the economic theory that the Obama Administration relied on in their Making Work Pay tax credit which was a part of the stimulus bill. The tax credit gave $400 or $800 if you a couple filing jointly to most Americans. This credit wasn’t given as a lump sum it was given quietly as a slight increase in their paychecks. Many people did not realize they were given a tax cut.

The thought behind this is if people received a lump sum check they would be inclined to save it while if it was given to them without their knowledge they would spend that extra income. The idea of the tax cuts being given to people without them noticing is from a school of thought known as behavioral economics. Behavior economics takes the stance that people may not always act in a rational manner. People rely on instincts, biases, and cognitive shortcuts to make decisions, which leads to poor choices.

Making Work Pay is based on the belief that people are more likely to spend money they have mentally accounted for as current income and not their mental assets account. What this means is people will measure how much they spend based on their paycheck and not the size of their bank account. This theory also believes a lump sum payment will be seen as an increase in wealth and there for is more likely to be saved. In a paper from University of Michigan by three economists they found the Making Work Pay did not get people to increase their spending, it actually caused them to spend less. The paper being released by the economists has come under fire due to it being reliant on a survey of people. To the behavioral economists people are not a reliable source of information; they are also blind to what shapes the financial choices they make. Another point behavioral economists make is that with traditional economics a tax cut is a tax cut and their shouldn’t be any different reaction to a lump sum and a slight increase in paychecks, both strategies should increase spending this was not the case.

The Making Work Pay tax cut was an attempt to give more working people larger paychecks in order to encourage them to spend more. During tough economic times the government takes actions that are thought to increase spending and there for spur the economy to grow and increase output. This strategy is to increase demand which causes people to buy more products which means businesses will increase output hire more workers and increase inventory. The most prominent of demand side theories is the Keynesian view. Keynes felt it was the government’s role to increase demand when the market was no longer operating as it should. He believed that the economy was fragile and not able to self-correct and therefore needed someone to increase demand.

The goal of the Making Work Pay tax credit was to give people more money to increase output. When people spend more they actually help create new jobs with more people willing to spend. There is a multiplier effect when it comes to the economy when a person spends money that causes more spending somewhere in the economy. One of the macroeconomic goals is to promote economic growth/ increases in output there are many way to grow an economy and some of these strategies conflict with each other. The strategies may differ greatly but they all have the same basic goal of increasing wealth and promoting prosperity within the economy. Behavioral economics is an important theory to understand because people don’t always do the rational thing and make mistakes, but it shouldn’t be assumed that they will always make irrational choices.