1. Supply-Side Policy: Short-Run Options Chapter 16 McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Supply-Side Policy
Any policies that alter the willingness or ability to supply goods at various price levels will shift the aggregate supply curve
How does the aggregate supply curve affect macro outcomes?
How can the aggregate supply curve be shifted?

3. Aggregate Supply
The macro economy experienced stagflation in the 1970s
Stagflation: The simultaneous occurrence of substantial unemployment and inflation
No shift of the aggregate demand curve can solve inflation and unemployment at the same time

4. Aggregate Supply
The shape and shifts in aggregate supply hold the clues on how stagflation may occur
Aggregate supply: The total quantity of output that producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus

5. Shape of the AS Curve
The response of producers to an AD shift is expressed in the slope and position of the AS curve
There are three views concerning the shape
Keynesian AS
Monetarist AS
Hybrid AS

6. Keynesian AS Little risk of inflation during a recession
Producers increase output, not prices, when aggregate demand picks up
Inflation becomes a problem only if demand increases beyond capacity

7. Monetarist AS Changes in money supply affect prices but not output
Rising prices don’t entice producers to increase output because costs rise just as fast
AS is vertical and located at full employment

8. Hybrid AS At low rates of output AS is horizontal
At high rates of output AS is nearly vertical
In between, AS is gently upward sloping
The closer the economy is to capacity, the greater the risk that fiscal or monetary stimulus will cause inflation

9. The Inflation-Unemployment Tradeoff
Fiscal and monetary policies cannot reduce unemployment and inflation at the same time
Because AS curve is upward-sloping
Rightward shifts of AD increase both prices and output
Leftward shifts of AD decrease prices and output

10. The Phillips Curve
Phillips curve: A historical (inverse) relationship between the rate of unemployment and the rate of inflation; commonly expresses a trade-off between the two
The trade-off originates in the upward-sloping AS curve

11. Unemployment Rate (percent) Inflation Rate (percent)
The Phillips Curve 1 2 3 4 5 6 7 11 10 9 8
Unemployment Rate (percent)
Inflation Rate (percent) B A C

12. The Phillips Curve Trade-Off
Increases in aggregate demand cause . . .
A trade-off between unemployment and inflation
REAL OUTPUT
PRICE LEVEL
UNEMPLOYMENT RATE
INFLATION RATE
Phillips curve
Aggregate
supply c C b B
AD3 a A
AD2
AD1

13. The Inflationary Flashpoint
Phillips curve indicates there is bound to be a trade-off between unemployment and inflation at some point in economic expansions and contractions
Inflationary flashpoint: The rate of output at which inflationary pressures intensify; point of inflection on AS curve

14. Shifts of the AS Curve
Many economists argue that the economy can attain lower levels of unemployment without higher inflation
Only a rightward shift of the AS curve can reduce unemployment and inflation at the same time

15. Shifts of Aggregate Supply
Output
Price Level
Rightward AS shifts reduce unemployment and inflation
AS1
AS2 E1 E2 AD

16. Phillips Curve Shift
The Phillips curve shifts left when the AS curve shifts right, and vice versa
The unemployment-inflation trade-off eases when the Phillips curve shifts to the left

17. Unemployment Rate (percent) Inflation Rate (percent)
Phillips Curve Shift 1 2 3 4 5 6 7 8
Unemployment Rate (percent)
Inflation Rate (percent)
PC1
Rightward AS shifts cause leftward Phillips curve shifts
PC2 a 4 b 2

18. Leftward AS Shifts: All Bad News
Leftward AS shifts create stagflation
Supply-side shocks can shift the AS curve to the left
Leftward shifts of aggregate supply cause rightward shifts in the Philips curve

19. Policy Tools Policy options to shift AS rightward include:
Tax incentives for saving, investment, and work
Human capital investment
Deregulation
Trade liberalization
Infrastructure development

20. Two Theories for Getting the Economy Moving
Supply-Side Theory
Keynesian Theory 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 invest more and try 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
In Keynesian economics, tax cuts are used to increase aggregate demand
Direct effects of taxes on the supply of goods are the concern of supply-side economists
Taxes not only alter disposable income but also affect incentives to work and produce

22. Marginal Tax Rates
Supply-side theory places special emphasis on marginal tax rates
Marginal Tax Rate: The tax rate imposed on the last (marginal) dollar of income
If the marginal tax rate is high, there is less incentive to work

23. Marginal Tax Rates
Progressive marginal tax rates discourage entrepreneurship
Growth rate, investment, and employment of small businesses are affected by marginal tax rates
Corporate investment decisions are also affected by corporate tax rates

24. Changes in Marginal Tax Rates Since 1915

25. Tax-Induced Supply Shifts
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 a one-time windfall and do not effect marginal tax rates
Tax rebate: A lump-sum refund of taxes paid

26. The Tax Elasticity of Supply
If the tax elasticity of supply were large enough, a tax cut might actually increase tax revenues

27. Savings and Investment Incentives
Supply-side economists favor tax incentives that encourage saving
Tax incentives for investment are an alternative lever for shifting aggregate supply
Examples include investment tax credits and cutting capital gains tax rates

28. Human Capital Investment
Tax incentives to businesses that offer worker training are a viable policy tool for future shifts in aggregate supply
Expansion and improvement of the education system through increases in education spending will develop human capital gradually

29. Human Capital Investment
Addressing discriminatory barriers through affirmative action programs can reduce artificial barriers between job seekers and job openings
Restructuring of transfer payments can reduce impact on labor supply

30. Deregulation
Government regulations limit the flexibility of producers and tend to raise production costs, shifting AS to the left
Government intervention in factor markets increases the cost of supplying goods and services in many ways

31. Minimum Wage and Mandatory Benefits
Minimum-wage laws increase the cost to employers of hiring additional workers, shifting the aggregate supply curve leftward
By requiring employers to provide specific fringe benefits, the government increases the cost of doing business

32. Occupational Health and Safety
OSHA, the Occupational Health and Safety Administration, forces employers to conform to certain minimum safety conditions at workplaces
The additional costs shift the aggregate supply curve to the left

33. Product Markets
Government regulations also raise costs in product markets
Regulation of transportation costs constrains producer’s ability to respond demand increases
Food and drug standards, enforced by the Food and Drug Administration (FDA), cause companies to incur additional costs as well

34. Reducing Costs
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

35. Easing Trade Barriers
In the factor markets, reducing tariffs or quotas on imports of production inputs decrease production costs and increase aggregate supply
In the product markets, foreign suppliers increase the quantity of output available at any given price level, helping flatten the AS curve

36. Easing Trade Barriers
Free trade pacts like the North American Free Trade Agreement (NAFTA) tend to shift aggregate supply rightward
Allowing immigration of foreign-born workers can increase the pool of skilled labor and help shift the aggregate supply curve to the right

37. Infrastructure Development
Improving the nation’s infrastructure reduces costs of supplying goods and services
Infrastructure: The transportation, communications, education, judicial, and other institutional systems that facilitate market exchanges

38. Expectations
Because investment is always a bet on future economic conditions, expectations directly affect the shape of the AS curve

39. Rebuilding America
The output of the American economy depends on public as well as private investment
Declining infrastructure investment reduces actual and potential output
Infrastructure improvements will increase aggregate supply, boosting both short-run and long-run economic outcomes

40. Supply-Side Policy: Short-Run Options End of Chapter 16
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.