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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 2 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. 3 THE KEYNESIAN VIEW 4 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) 5 Aggregate supply P5 P4 AD5 AD4 QN OUTPUT (real GDP per period) 6 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 8 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. 9 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 12 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 13 SHIFTS OF THE AS CURVE 14 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) 15 PHILLIPS CURVE SHIFT 16 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 17 Rightward AS shifts cause leftward Phillips curve shifts PC2 2 3 4 5 6 Unemployment Rate (percent) 7 8 18 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. 19 20 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. 21 TAX INCENTIVES Keynesian Theory 22 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. 23 24 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. 25 TAX-INDUCED SUPPLY SHIFTS 26 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 27 28 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 29 30 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. 31 32 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. 33 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.). 34 Tax incentives to businesses that offer worker training is a viable policy tool for future shift in aggregate supply. 35 36 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. 37 38 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. 39 40 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. 41 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. 42 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. 43 44 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. 45 46 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 47 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. 48 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. 49 EXPECTATIONS 50 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. 51 End of Chapter 16 SUPPLY-SIDE POLICY: SHORT-RUN OPTIONS 52