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

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?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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

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

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

Changes in Marginal Tax Rates Since 1915

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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