Download AGGREGATE SUPPLY THREE VIEWS OF AS

AGGREGATE SUPPLY

The impetus for examining the supply side of the
macro economy sprung up in the stagflation of the
1970s.

Stagflation is the simultaneous occurrence of
substantial unemployment and inflation.
No shift of the aggregate demand curve can
increase inflation and unemployment at the same
time.
 The explanation for stagflation is found in the
shape in the aggregate supply curve and potential
AS shifts.

Chapter 16
SUPPLY-SIDE POLICY:
SHORT-RUN OPTIONS
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AGGREGATE SUPPLY
THREE VIEWS OF AS
Aggregate supply is the total quantity of output
that producers are willing and able to supply at
alternative price levels in a given time period,
ceteris paribus.
 The response of producers to an AD shift is
expressed in the slope and position of the
aggregate supply curve.

There are three views concerning the shape of
the aggregate supply curve.
 Keynesian View:

 AS
 At
is horizontal up to full employment.
employment
this point, AS becomes vertical.
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THE KEYNESIAN VIEW
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THE MONETARIST VIEW
PRICE L
LEVEL
(average price perr unit of output)
PRICE LE
EVEL
(average price per unit of output)
AS is vertical and located at full employment.
Aggregate supply
P1
AD2
AD3
AD1
Q1
Q*
OUTPUT (real GDP per period)
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Aggregate supply
P5
P4
AD5
AD4
QN
OUTPUT (real GDP per period)
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THE CONSENSUS VIEW
At low rates of employment AS is horizontal and
at high rates of employment AS is nearly
vertical.
 In between
between, AS is gently upward sloping.
sloping
 The closer to capacity, the greater the risk that
fiscal or monetary stimulus will spill over into
price inflation.

PRICE LE
EVEL
(average price per unit of output)
THE CONSENSUS VIEW
AS
Monetarist segment
IInflation
fl ti
accelerating
Keynesian segment
AD7
AD6
Unemployment declining
Q6 Q7
OUTPUT (real GDP per period)
7
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DEMAND RESTRAINT
THE INFLATION-UNEMPLOYMENT TRADEOFF
The economy cannot attain both full
employment and price stability at the same
time – at least not with fiscal and monetary
policies.
 Monetary and fiscal stimulus shift the
aggregate demand curve rightward.
 All rightward shifts of the aggregate demand
curve increase both prices and output if the
aggregate supply curve is upward-sloping.
If the aggregate supply curve is upward-sloping,
leftward shifts of the aggregate demand curve
cause both prices and output to fall.
 Demand-side
Demand side policies alone can never succeed
completely.
 They will always cause some unwanted inflation
or unemployment.


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THE PHILLIPS CURVE
THE PHILLIPS CURVE
The Phillips curve is a historical (inverse)
relationship between the rate of unemployment
and the rate of inflation.
Commonly expresses a tradeoff between
the two.
Inflation Rate
e (percent)

10
11
10
9
8
7
6
5
4
3
2
1
0
11
B
A
C
1
2
3
4
5
Unemployment Rate (percent)
6
7
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THE PHILLIPS CURVE
The tradeoff between unemployment and
inflation originates in the upward-sloping AS
curve.
Increases in aggregate
demand causes . . . . .
A trade-off between
unemployment and inflation.
Aggregate
supply
C
B
A
AD3
AD2
AD1
Phillips curve
INFLATION RAT
TE
PRICE LEVEL
L

THE PHILLIPS CURVE TRADE-OFF
REAL OUTPUT
c
b
a
UNEMPLOYMENT RATE
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SHIFTS OF THE AS CURVE
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SHIFTS OF AGGREGATE SUPPLY
The unemployment inflation trade-off implied
by the upward sloping AS curves is not etched
in stone.
 Many
y economists argue
g that the economyy can
attain lower levels of unemployment without
higher inflation as demonstrated in the 1990s.
 Only a rightward shift of the AS curve can
reduce unemployment and inflation at the
same time.
Price Lev
vel
(average price per unit of output)

Rightward AS shifts reduce AS1
unemployment and inflation
E1
AS2
E2
AD
0
Output (real GDP per period)
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PHILLIPS CURVE SHIFT
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PHILLIPS CURVE SHIFT
When the AS curve shifts, the Phillips curve
shifts as well.
 When the Phillips curve shifts to the left, the
unemployment inflation trade-off
unemployment-inflation
trade off eases.
eases

Inflation Rate ((percent)
PC1
a
4
b
2
1
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Rightward AS shifts cause
leftward Phillips curve shifts
PC2
2
3
4
5
6
Unemployment Rate (percent)
7
8
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THE MISERY INDEX

LEFTWARD AS SHIFTS: ALL BAD NEWS
The misery index is a simple sum of the
inflation and unemployment rates.
Leftward AS shifts are real nightmares.
 A natural disaster can trigger a leftward shift of
the AS curve, especially in smaller nations.
 In
I a large
l g economy lik
like th
the U
U.S.,
S lleftward
ft d shifts
hift
of aggregate supply are less dramatic.


Rightward shifts of the aggregate supply curve
always generate desirable macro outcomes.
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TWO THEORIES FOR GETTING THE ECONOMY
MOVING
SHIFTS OF AGGREGATE SUPPLY

Supply-Side Theory
The following policy options can shift the
aggregate supply curve rightward:
 Tax
incentives for saving, investment and work.
capital investment.
 Deregulation.
 Infrastructure development.
 Human

All of these policies have the potential to
change supply decisions independently of any
changes in aggregate demand.
1
Cut tax rates to boost
incentives to work and invest.
1
Cut tax rates to put more
disposable income in people’s
hands.
2
Firms
Fi
invest
i
t more and
d try
t new
ventures; jobs are created;
people work harder aggregate
supply increases.
2
People use increased income
to buy more goods and
services:
aggregate demand increases.
3
New investment and labor
bring increased output.
3
To meet new demand,
companies expand output.
4
Employment rises, new plants go
up, the whole economy expands.
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TAX INCENTIVES
Keynesian Theory
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MARGINAL TAX RATES
In Keynesian economics, tax cuts are used to
increase aggregate demand.
 The direct effects of taxes on the supply of
ggoods are the concern of supply-side
pp y
economists.
 Supply-side theory places special emphasis on
marginal tax rates.

In our progressive income-tax system, marginal
tax rates increase as more income is received.
 The top marginal tax rate on income has varied
from a low of 12 percent to a high of 91
percent.
 In 2000, the highest marginal tax rate on
personal income was 39.6 percent.
 It is presently situated at 35%.

 Marginal
Tax Rate - The tax rate imposed on the
last (marginal) dollar of income.
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MARGINAL TAX RATES
INVESTMENT
Supply-side theory emphasizes how these
varying tax rate affect work, investment, and
production decisions, i.e. aggregate supply.
 The marginal
g
tax rate influences the financial
incentive to increase one’s work.


 Investment
– Expenditures on (production of) new
plant, equipment, and structures (capital) in a given
time period, plus changes in business inventories.
 If
the marginal tax rate is high, there is less
incentive to work.

High marginal tax rates also discourages
investment.

High progressive tax rates discourage entry into
self-employment.
If high tax rates discourage investment,
aggregate supply will be constrained.
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TAX-INDUCED SUPPLY SHIFTS
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CHANGES IN MARGINAL TAX RATES
A reduction in marginal tax rates shifts the
aggregate supply curve to the right.
 Work effort, entrepreneurship, and investment
increase.
 Tax rebates do not shift AS because they are
one-time windfall and have no effect on
marginal tax rates.

A

100%
Top tax rate, in percent
80
60
40
20
tax rebate is a lump-sum refund of taxes paid.
To stimulate aggregate supply, tax rates must
be reduced, particularly at the margin.
0
1920
1930
1940
1950
1960
1970
1980
1990
2000
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THE TAX ELASTICITY OF SUPPLY
THE TAX ELASTICITY OF SUPPLY
The expected response of labor and capital to a
change in tax rates is summarized by the tax
elasticity of supply.
 The tax elasticity of supply is the percentage
change in quantity supplied divided by the
percentage change in tax rates.

If the tax elasticity of supply were large enough,
a tax cut might actually increase tax revenues.
In reality, the tax elasticity of supply is quite
small (around 0.15).

Tax elasticity of supply
% change in quantity supplied
=
% change in tax rate
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SAVINGS INCENTIVES

INVESTMENT INCENTIVES
Supply-side economists emphasize the
importance of saving in financing investment
and economic growth.
Tax incentives for investment are an alternative
lever for shifting aggregate supply.
 Examples include cutting capital gains tax rates
and investment tax credits.
credits

 Saving
is that part of disposable income not spent
on current consumption.
 It is disposable income less consumption.

Supply-side economists favor tax incentives
that encourage saving as well as greater tax
incentives for investment.
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HUMAN CAPITAL INVESTMENT
STRUCTURAL UNEMPLOYMENT
Human capital is the knowledge and skills
possessed by the work force.
 The ability to supply goods and services
depends on its human capital as well as its
physical capital.

Structural unemployment is the unemployment
caused by a mismatch between the skills (or
location) of job seekers and the requirements
(or location) of available jobs.
 Investments in human capital reduce structural
employment and shift the aggregate supply
curve rightward.

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WORKER TRAINING

EDUCATION SPENDING
Worker training increases labor productivity.
Expanding and improving the efficacy of the
education system will increase human capital.
 Education spending is more likely to develop
human capital gradually rather than to spur
short-term economic growth.

 Labor
productivity is the amount of output
produced by a worker in a given period of time.
 Measured as output per hour (or day, etc.).

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Tax incentives to businesses that offer worker
training is a viable policy tool for future shift in
aggregate supply.
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AFFIRMATIVE ACTION
TRANSFER PAYMENTS
Race and gender issues (as opposed to lack of
skills and experience) can create artificial
barriers between job seekers and job openings.
 If discrimination tends to shift the aggregate
gg g
supply curve leftward, the reducing
discriminatory barriers should shift it to the
right.
 From a supply-side perspective, laws that forbid
discrimination are welcome and should be
enforced.

Transfer payments are payments to individuals
for which no current goods or services are
exchanged, such as social security, welfare,
unemployment benefits.
 Welfare programs can discourage workers from
taking jobs.

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DEREGULATION
FACTOR MARKETS
Another way the government affects the shape
and position of the aggregate supply curve is
through regulation.
 The added costs of production due to
regulation shift the aggregate supply curve to
the left.


Government intervention in factor markets
raises the cost of supplying goods and services
in many ways.
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MINIMUM WAGE
MINIMUM WAGE
The minimum wage was created by the Fair
Labor Standards Act of 1938.
 The goal of the minimum-wage law is to ensure
workers a decent standard of living.
living
 By prohibiting employers from using lower-paid
workers, it limits the ability of employers to hire
additional workers.


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In the absence of a minimum wage, employers
would hire and train more teenagers and other
low-skill workers.
 Minimum-wage
Minimum wage laws shift the aggregate supply
curve leftward, making it more difficult to
achieve full employment with stable prices.
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MANDATORY BENEFITS
OCCUPATIONAL HEALTH AND SAFETY
By requiring employers to provide specific
fringe benefits, the government increases the
cost of doing business.
 The higher costs shift the aggregate supply
curve leftward.

OSHA, the Occupational Health and Safety
Administration, forces employers to conform to
certain minimum safety conditions at
workplaces.
 Again, the additional costs shift the aggregate
supply curve to the left.

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PRODUCT MARKETS
FOOD AND DRUG STANDARDS
Government regulations also raise costs in product
markets.
 At the federal level, various agencies regulate the
output and prices of transportation services.
 The regulation of air, land, and sea transportation
costs constrains the ability of producers to
respond to increases in demand and prevents new
producers from entering the market.


The Food and Drug Administration causes
companies to incur additional costs as they
must ensure their product(s) conform to FDA
standards.
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REDUCING COSTS
EASING TRADE BARRIERS
The basic contention of supply-side economists
is that the regulatory costs are now too high.
 They favor deregulating the production process
in order to shift aggregate supply to the right.
right


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Government regulation of international trade
also affects aggregate supply.
 Reducing tariffs or quotas on imports of
production inputs would decrease production
costs and increase aggregate supply.
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PRODUCT MARKETS
IMMIGRATION AND INFRASTRUCTURE
Foreign-produced goods increase the quantity
of output available at any given price level.
 Free trade pacts like the North American Free
Trade Agreement (NAFTA) tend to shift
aggregate supply rightward.

Immigration of foreign-born workers can
increase the pool of skilled labor, shifting the
aggregate supply curve to the right.
 Another way to reduce the costs of supplying
goods is to improve the nation’s infrastructure.

 Infrastructure
is the transportation,
communications, education, judicial, and other
institutional systems that facilitate market
exchanges.
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EXPECTATIONS
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DECLINING INFRASTRUCTURE INVESTMENT
Like private capital, public capital contributes
to our production possibilities.
 Investment in public infrastructure has been
declining ever since a peak of about 3.5% of
GDP in the mid-1960s.
mid 1960s
 Declining infrastructure investment reduces
actual and potential output.

Because investment is always a bet on future
economic conditions, expectations directly
affect the shape of the AS curve.
 The output of the American economy depends
not only on private investment, but on public
investment as well.

 The
transportation system is not keeping up with a
growing economy.
 Delays in infrastructure investment will only worsen
the situation.
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End of Chapter 16
SUPPLY-SIDE POLICY:
SHORT-RUN OPTIONS
52