Download Concept 1: Aggregate Supply

Macroeconomics
Unit 16
Supply-Side Policy and Short-Run
Economic Options
The Top Five Concepts
Introduction
This unit discusses methods to achieve economic growth in the
short-run.
You are also introduced to supply-side theory and its
application to the aggregate supply curve. If supply is not
changed along with demand, there is a tradeoff between
inflation and unemployment. With demand side changes, as
unemployment is reduced inflation occurs; if inflation is reduced
unemployment increases.
Supply-side theory also contains incentives to boost aggregate
demand.
Concept 1: Aggregate Supply
In prior chapters we have examined policies designed to affect
aggregate demand.
Fiscal (Keynesian) and Monetary policies both focus on
aggregate demand.
Changing aggregate demand alone causes price changes
which may not be desirable.
Shifting aggregate supply alone and/or with shifts in aggregate
demand may provide a better economic outcome. This is
Supply-Side Theory.
Concept 1: Aggregate Supply
Supply-side theories became popular in the late 1970s and
early 1980s as a result of the economic conditions at that time.
In the mid 1970s we had an inflation rate of 12.3% and an
increase in unemployment to 5.6%.
Also in the late 1970s and early 1980s we had excessive
inflation and high unemployment causing stagflation.
Stagflation occurs when both unemployment and inflation rise
significantly together.
Concept 1: Aggregate Supply
Keynes believed that the aggregate supply curve is horizontal
until full employment is reached, then it becomes vertical.
If that’s true, then rightward shifts in aggregate demand do not
produce an increase in price if output is below the economy’s
capacity to produce.
Once aggregate demand reaches the full capacity of the
economy, further increases in demand will cause prices to rise
without a corresponding increase in supply.
Concept 1: Aggregate Supply
Monetarists believe that the aggregate supply curve is vertical
in the long run.
Changes in the money supply can cause aggregate demand to
shift, but aggregate supply remains fixed over all levels of
output.
Prices will change as aggregate demand shifts.
Aggregate supply remains fixed at the long-run natural rate of
unemployment according to Monetarists.
Concept 1: Aggregate Supply
The consensus (and perhaps logical) view is that the aggregate
supply curve starts out horizontally and becomes vertical at
high levels of output.
The middle portion of the supply curve has an upward slope.
Changes in demand within the middle portion of the AS curve
lead to price changes. Price changes cause fiscal and
monetary policy to be less effective.
The Consensus View of Aggregate Supply
(average price per unit)
PRICE LEVEL
AS
Monetarist segment
Inflation
accelerating
Keynesian segment
AD
Unemployment declining
Q
Q
OUTPUT (real GDP per 6period)7
AD1
Concept 2: Phillips Curve
The implication associated with the consensus view is that
policies designed to shift aggregate demand alone will never be
completely effective.
Inflation or unemployment will result if demand-side policies are
used alone.
The tradeoff between unemployment and inflation is expressed
by the Phillips Curve.
Concept 2: Phillips Curve
The Phillips curve is an inverse relationship between the rate of
unemployment and the rate of inflation. When one increases
the other decreases.
This relationship was first recognized in the U.S. during the first
half of the 20th century, especially during the time period after
World War II.
Unemployment of 8% produced inflation of 4%. When either
one when up, the other fell. For example, if unemployment was
reduced to 4%, inflation increased to 8%.
Inflation Rate (percent)
The Phillips Curve
At any point on the curve, there is an
inverse relationship between
unemployment and inflation. As you move
down the curve, unemployment increases
and inflation decreases.
11
10
9
8
7
6
5
4
3
2
1
0
1
2
3
4
5
Unemployment Rate (percent)
6
7
Concept 3: Shifting the AS Curve
During the 1990s our economy experienced significant growth
without inflation.
Unemployment and inflation remained at historic lows.
At first this appears to contradict the Phillips curve.
However, we also had a shift in AS to the right. What affect did
this rightward shift of AS have on the Phillips curve?
Concept 3: Shifting the AS Curve
When the AS curve shifts to the right, aggregate supply has
increased.
Increasing aggregate supply reduces prices and decreases
unemployment. The rightward shift of the aggregate supply
curve produces a leftward shift in the Phillips curve.
When the Phillips curve shifts to the left, the tradeoff between
inflation and unemployment is reduced. Simply put, prior to the
curve shifting if unemployment was reduced by 4%, inflation
may have increased by 3%. After the shift, if unemployment is
reduced by 4%, inflation increases only 1%.
Aggregate Supply Shifting Right
(average price per unit of output)
Price Level
Rightward shifts of AS reduces
unemployment and inflation
AS1
E1
AS2
E2
AD
0
Output (real GDP per period)
Inflation Rate (percent)
Phillips Curve Shift
6
When AS shifts to the right, the Phillips Curve
shifts left, reducing the tradeoff between
inflation and unemployment.
PC1
PC2
4
2
1
2
3
4
5
6
Unemployment Rate (percent)
7
8
Concept 4: Shifts of Aggregate Supply
Okun developed an index that measures
the effects of both inflation and
unemployment changing together
(stagflation).
The index is called the Misery index. The
Misery index adds together the
unemployment and inflation rates.
For example, if inflation is 5% and
unemployment is 6%, the Misery index is
11%.
Concept 4: Shifts of Aggregate Supply
The Misery index indicates the level of economic distress
experienced within the economy caused by stagflation
Generally, an index of 6 or less is not considered to be a
concern.
Higher levels, like those experienced during the time Reagan
was first elected president (Misery Index = 19.6, with 12.5%
inflation, and 7.1% unemployment), are considered harmful to
the economy. President Reagan’s economic policies
successfully reduced inflation and unemployment which
reduced the misery index although budget deficits increased.
Concept 5: Supply-side Policy
The purpose of supply-side policy is to shift AS to the right.
Anytime AS shifts to the left, output declines and prices rise.
Leftward AS shifts are usually caused by external shocks
(natural disasters, OPEC oil supply reductions, Sept. 11
attacks, etc.). They can also be caused by increased
government regulation and marginal tax rate increases.
There are four main policy levers that can be used to shift AS to
the right. These are the basis of supply-side theory.
Concept 5: Supply-side Policy
Tax Incentives for saving,
investment, and work.
Human capital investment.
Deregulation.
Infrastructure development.
Let’s look at each one…
Tax Incentives
Tax cuts are a popular tool used on the demand-side to
stimulate AD.
Tax cuts on the supply-side are focused on the marginal tax
rate. The marginal tax rate is the tax rate imposed on the last
dollar of income.
This could be the tax on individuals working overtime, people in
the highest tax bracket, or the taxes a corporation pays if its
output increases.
Tax Incentives
High tax rates discourage investment by corporations as well
as discourage workers from working overtime or seeking higher
paying jobs.
Tax cuts to stimulate the economy on the supply-side are
designed to reduce marginal tax rates.
If marginal tax rates are reduced, workers have a greater
incentive to work harder and longer hours.
Marginal tax rate reductions also encourage companies to
expand output and investment.
Tax Incentives
The effectiveness of tax cuts can be measured by looking at
the tax elasticity of supply.
The tax elasticity of supply measures the percentage change
in the quantity of labor or capital supplied, divided by the
percentage change in tax rates.
Tax elasticity of supply (E) =
% change in quantity supplied / % change in tax rate
The value (E) provides us with an indication of how consumers
or businesses will respond to a tax cut.
Tax Incentives
E is usually expressed as an absolute value (not negative).
For example, if E = 1.5, a 10% corporate tax cut would lead to
a 15% increase in output (1.5 X 10%).
If E = .5, then a 20% individual tax cut would lead to a 10%
increase in worker output (.5 X 20%).
The higher the value of E, the greater the increase in output
that can be achieved from a tax cut.
Tax Incentives
Savings incentives are also an important part of any tax
package.
Demand-side policies treat savings as a leakage from the
circular flow. Supply-side policies believe savings is an
important future component of investment and growth.
Supply-side policies that provide tax incentives for savings and
investment can eventually shift AS rightward.
Tax Incentives
Individual savings incentives consist of IRAs, 401Ks, reducing
taxes on interest earned, and possibly reducing capital gains
taxes.
Investment savings incentives consist of capital gains tax
reductions, investment tax credits, and Economic Renaissance
Zones which provide special tax and accounting incentives for
business to develop and expand in underdeveloped or
abandoned areas.
Human Capital Investment
Human capital is the knowledge
and skills possessed by the work
force. An investment in human
capital could consist of finishing high
school, attending college or a trade
school, in-house training, and
management training.
Human capital investment increases
the quality and ability of the
workforce.
Human Capital Investment
Human capital investment reduces structural unemployment
which is the mismatch between worker skills and jobs available.
Human capital investment improves labor productivity – leads
to higher output per worker.
Welfare programs that provide incentives for individuals to seek
training and return to the workforce also are human capital
investments.
Human Capital Investment
Tax incentives for business to provide additional training or
educational assistance to employees can help increase human
capital investment.
Tax incentives directed at individuals can also provide
incentives to help individuals increase their skills and abilities
(tuition deductions, etc.).
The investment in human capital has one long term goal: to
shift AS to the right.
Deregulation
Deregulation is the reduction or elimination of government
rules or standards which do not serve a useful purpose.
Most government regulation increases employer costs – some
are necessary but others may be outdated or have high
compliance costs.
Minimum wages, mandatory benefits (FMLA), OSHA
compliance, FDA standards, and EPA requirements are
examples of regulation.
Deregulation - Trade Barriers
U.S. regulation of foreign trade, combined with foreign
government regulation, can affect AS.
Quotas and tariffs on imported goods reduces output or
increases the costs of production.
Foreign markets that restrict U.S. imports or impose tariffs
reduces our ability to sell in foreign markets.
If quotas or tariffs are eliminated, increased production can
occur which shifts AS to the right.
Infrastructure Development
Infrastructure is the
transportation, communication,
education, judicial, and other
systems that assist market
exchanges.
An investment in infrastructure
means you are improving it.
Widening highways, improving
communications using fiber optic
or satellite technology, and
expanding airports are examples.
Infrastructure
Subsidies or scholarships to
attend college or build new
facilities, and adding judges
improves infrastructure.
Improving the infrastructure
shifts AS to the right, and
because of the spending activity
on infrastructure, it will also shift
AD to the right.
Expectations
We have learned that expectations are a determinant of
demand. Consumer expectations affect the demand curve.
Expectations also affect the supply curve.
Business investment to increase output is dependent upon their
view of the future. If businesses expect better economic and
political conditions, investment will increase and AS shifts to the
right.
If businesses are concerned about future economic and/or
political conditions, investment will likely decline.
Summary
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Stagflation.
Phillips curve.
Keynesian, Monetarist, Consensus views.
Understand the misery index.
Rightward and leftward shifts of the aggregate supply curve.
Policy levers for shifting aggregate supply.
Marginal tax rate.
Tax elasticity of supply and what the value of E indicates.
Human capital investment.
Deregulation.
International trade.
Infrastructure.
Expectations.