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Schiller_TET_15e_Chap016_PPT.pptxSupply-Side Policy:
Short-Run Options
Why the short-run AS curve slopes upward.
How an unemployment–inflation trade-off arises.
How shifts of the aggregate supply curve affect macro outcomes.
The tools of supply-side policy.
LO16-1
LO16-2
LO16-3
LO16-4
16
LEARNING OBJECTIVES
After learning about this chapter, you should know
CHAPTER
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1
Supply-Side Policy
Fiscal and monetary policies focus on the demand side of the macro economy. These policies shift the aggregate demand curve.
Policies that alter the willingness or ability to supply goods at various price levels will shift the aggregate supply curve. They are supply-side policies.
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Fiscal and monetary policy are relatively short-run policies that work on AD.
Supply-side policies are much more long-run policies that work on AS.
They must be longer-run because they rely on changing the capability and the intention to produce, which takes time.
2
Supply-Side Policy II
In this chapter we focus on two issues:
how does the aggregate supply curve affect macro outcomes?
how can the aggregate supply curve be shifted?
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Again, the macro outcomes of significance here are unemployment, inflation, and GDP growth.
Draw an AD-AS graph on the board. Shift AS left: unemployment rises, inflation rises, and GDP falls – a triple bad.
Shift AS right: unemployment falls, inflation falls, and GDP rises – a triple good.
3
Aggregate Supply
In the 1970s, the U.S. experienced stagflation: the simultaneous occurrence of substantial unemployment and inflation.
Shifting AD to “fix” stagflation is not possible.
Increase AD: unemployment falls and inflation rises.
Decrease AD: unemployment rises and inflation falls.
Supply-side policy arose to provide an answer to stagflation.
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The term “stagflation” became a favorite new headline in the 1970s. It was coined by a British politician, Iain Macleod, in a speech to Parliament in 1965.
Keynesians were in total command of the economics world at the time.
Their favorite technique, shifting AD, couldn’t fix the problem. So they were out of arrows in their quiver.
In New York a small group of economists, newspaper people, and politicians met several times and came up with what came to be called supply-side policy as an antidote to stagflation.
4
Shape of the AS Curve
The Keynesian version:
AS is horizontal until Q*, is reached.
An AD shift to the right in recession increases Q but does not increase P.
Inflation becomes a problem only after AD shifts past Q*, the production capacity and AS becomes vertical.
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Remember, Keynesians never considered that moving AS was of any relevance or consequence.
They focused solely on AD. So their opinion of AS was molded by how it affected the AD shift.
5
Shape of the AS Curve II
The Monetarist version:
Changes in the money supply affect prices but not output.
An AD shift to the right increases inflation.
AS is a long-run concept and is vertical.
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Similarly, monetarists are focused on the shift of AD. Their concept of AS is long-run at the “full-employment” level of GDP.
6
Shape of the AS Curve III
The Hybrid version:
Most economists now see an AS curve with an upward slope that increases near full employment.
Inflation accelerates in that region of the curve as AD shifts right.
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This version of the AS curve includes the horizontal version of the Keynesians at levels of high unemployment and the vertical version of the monetarists at times of stressing the capacity of the country to produce (boom times). A transition zone lies in between as the AS crosses the full-employment GDP level.
7
Impact of the Hybrid AS Curve
Shifts of AD affect both prices and output.
Outcomes of fiscal and monetary policy depend on how close the economy is to full employment.
The closer to full employment we are, the greater the risk that fiscal or monetary stimulus will spill over into inflation.
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Most activity occurs in the transition zone.
8
Inflation-Unemployment Trade-Off
The message of the upward-sloping AS curve is that demand-side policies alone can never succeed completely; they will always cause some unwanted inflation or unemployment.
This is the inflation-unemployment trade-off, which is expressed in the Phillips curve.
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The modern-day Phillips curve grew out of the work of A. W. Phillips, who studied the relationship of wages and prices in the U.K.
A very instructive documentation of the economic history of the last 50 years can be seen by following the Phillips curve.
The most significant revelation is just how few times in that half-century AD was the only curve that shifted. In other words, AS shifts have had a greater impact over the last half-century than AD shifts.
Phillips curve for the U.S.: http://www.j-bradford-delong.net/multimedia/USPCurve.html.
9
Inflation-Unemployment Trade-Off II
As the economy moves from point A to B to C (left picture), the inflation-unemployment trade-off shifts from point a to b to c (right picture) on the Phillips curve.
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The AS curve is the mirror image of the Phillips curve.
10
The Inflationary Flashpoint
The upward-sloped AS curve has a point at which inflation rockets upward as the decrease in unemployment slows.
It is called the inflationary flashpoint: the output at which inflationary pressures intensify; the point on the AS curve where slope increases sharply.
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As the AS transitions from flat to vertical, there is a point where inflation accelerates.
11
Shifts of the AS Curve
Rightward shift of AS:
Good news! Reduces unemployment and inflation at the same time.
Also increases output.
Shifting AD cannot do this.
Leftward shift of AS:
Bad news! Both unemployment and inflation increase, and output decreases.
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This demonstrates what happens when AS shifts. Right? Good! Left? Bad!
12
Relation between AS and Phillips Curve
When AS shifts right, the Phillips curve shifts left.
This eases the inflation-unemployment trade-off.
Both inflation and unemployment fall.
When AS shifts left, the Phillips curve shifts right.
This makes the inflation-unemployment trade-off much more severe.
Both inflation and unemployment rise.
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This simply verbalizes the mirror image quality.
13
The Misery Index
Misery index: a simple sum of the inflation and unemployment rates.
If AS shifts right, both elements decrease and the misery index falls sharply.
If AS shifts left, both elements increase and the misery index rises sharply.
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Another big headline in the 1970s. This term was coined by Arthur Okun.
AS shifts left? Misery index rises.
AS shifts right? Misery index falls.
14
What Shifts the AS Curve?
Shifting AS right:
Policies that provide incentives for suppliers to increase production.
Tax incentives for saving, investment, and work.
Human capital investment.
Deregulation.
Trade liberalization.
Infrastructure development.
Generates desirable macro outcomes.
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Anything that increases the reward for working, investing, and saving.
Anything that improves productivity.
Anything that lowers costs of operation, including taxes and compliance with regulation.
15
What Shifts the AS Curve? II
Shifting AS left:
Policies that provide disincentives for suppliers to increase production.
Tax increases for saving, investment, and work.
Deteriorating human capital investment.
Excessive, costly regulation.
Trade restrictions.
Decaying infrastructure.
Negative external shocks, such as natural disasters and war.
Generates undesirable macro outcomes.
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Anything that decreases the reward for working, investing, and saving.
Anything that degrades productivity.
Anything that raises costs of operation, including taxes and compliance with regulation.
Plus external effects.
16
Tax Incentives
Keynesians will cut taxes to increase AD.
Supply-siders note that high tax rates destroy the incentive to work and produce, which ends up reducing output.
Lowering tax rates encourage people to earn more because more ends up in disposable income and less goes to the government.
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This contrasts the different ways of looking at tax law changes.
17
Tax Incentives II
Supply-siders emphasize a reduction in marginal tax rates for both workers and firms.
Marginal tax rate: the tax rate imposed on the latest earned (marginal) dollar of income.
High marginal tax rates provide a disincentive to:
increase their earnings.
start or expand a business.
increase investment spending.
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In the Reagan era, when the top tax rate was reduced from 70% to 35%, an entrepreneur who could do some extra work and earn an extra $100,000 would see his or her added take-home pay more than double from $30,000 to $65,000.
18
Marginal Tax Rates
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Top marginal income tax rates in the US since 1914.
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Tax Incentives III
High marginal tax rates will shift AS to the left.
A reduction in marginal tax rates will shift AS to the right.
On the other hand, a tax rebate (one-time tax refund) adds to disposable income but does not affect the marginal tax rate, so AS does not shift.
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Keynesians, of course, would prefer the tax rebate. Its only effect would be to shift AD.
20
Savings Incentives
Keynesians treat saving as a deterrent to spending, a leakage.
Supply-siders emphasize the importance of saving for financing more investment and economic growth.
They favor tax incentives that encourage saving and greater tax incentives for investment.
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Savings provide the input for the credit market.
Encouraging saving would expand the availability of credit and lower interest rates with no Fed involvement.
Tax incentives for investment encourage more of it to occur.
Both will increase investment and shift AS, both short-run and long-run, to the right.
21
Investment Incentives
Supply-siders advocate tax incentives for investment.
Reduced taxes on capital gains and dividends.
Larger capital expensing of new investment.
The goal is to expand investment spending, which increases the capacity to produce. This will shift AS to the right.
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Summarizes the supply-siders point on investment incentives.
22
Human Capital Investment
Supply-siders encourage investments in human capital – the knowledge and skills possessed by the workforce – to provide the knowledge and skills needed to reduce structural unemployment.
This can be done by providing tax credits to employers who offer more worker training.
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The goal here is to improve productivity.
Productivity leads to lower per-unit costs.
Lower per-unit costs lead to expansion of production.
23
Other Human Capital Incentives
Expand and improve the educational system.
Reduce discriminatory barriers by using affirmative action programs.
Keep transfer payments from becoming excessive and providing a disincentive for recipients to take a job.
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All of these will aid in shifting AS to the right.
24
Deregulation
When government imposes regulations that directly affect employment and production decisions, it affects the AS curve.
Excessive regulation is costly to producers and will shift AS to the left.
Decreased regulation (or deregulation) reduces costs for producers and will shift AS to the right.
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One of the big uncertainties that slowed the economic recovery in 2010-2012 was the huge uncertainty among business about how much of an increase in regulatory costs they would face when all the new banking, health, and environmental regulations in the pipeline went into effect.
They envisioned rapidly rising regulatory costs, which would shift AS left and cause the triple bad.
25
(De)regulation
Regulations have good reasons for existing but shift AS to the left by increasing costs to producers. Examples:
minimum wage.
mandatory benefits.
occupational health and safety.
transportation costs.
food and drug standards.
environmental protection.
Supply-siders contend that regulatory costs are now too high.
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If high regulatory costs shift AS left and cause higher unemployment, higher inflation, and slow GDP growth, it might be time to do a benefit-cost analysis on some of the offending regulations.
26
Easing Trade Barriers
When production costs rise, AS shifts left.
Tariffs (taxes on imported goods) make input costs higher.
Immigration restrictions make it more difficult to overcome skill shortages in the labor market.
Supply-siders say that tariff reduction on inputs and improvement in the flow of immigrant workers cause production costs fall and AS will shift right.
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Protection occurs when tariffs and quotas are passed by Congress with the rationale of “protecting” American jobs. We will debunk that myth in the international chapters. What protectionism really does is raise costs of all production and destroy jobs in exporting industries.
27
Adverse Supply-Side Policies
The following policies shift AS to the left:
higher marginal tax rates for individuals and businesses.
increased taxes on saving and investment.
letting infrastructure deteriorate.
increased government regulation.
increased trade barriers.
When AS shifts left, output decreases, unemployment rises, and inflation increases.
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Supply-side policy is one-way: advocate practices that will shift AS right. Never advocate practices that will shift AS left.
28
Application: The Economy Tomorrow
Rebuilding America.
We must maintain, improve, expand, and in some cases replace our public infrastructure.
Delay in doing so imposes severe costs in the everyday activity of America.
In the economy tomorrow:
deteriorating or inadequate infrastructure will shift the AS curve to the left.
modernizing and updating infrastructure will shift the AS curve to the right.
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Some infrastructure improvements in the world have skipped a generation or two in technology. In Africa and Asia, communications jumped over the landline telephone directly to cell phone technology, for example.
29
Application: The Economy Tomorrow II
Infrastructure: The transportation, communications, education, judicial, and other institutional systems that facilitate market exchanges.
Improving these institutional structures makes commerce flow easier and therefore reduces costs.
Reducing costs will cause the AS curve to shift right.
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Nobody advocates the wanton and deliberate deterioration of infrastructure.
However, when funds are allocated for infrastructure, they seem to have to go through the “pork barrel” and go to projects that are more political than necessary.
30
Revisiting the Learning Objectives
LO16-1 Explain why the short-run AS curve slopes upward.
There is a maximum capacity to produce at any time in an economy. As output nears that capacity, output increases slow down but price increases accelerate.
The AS curve traces this phenomenon.
16-31
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Here begins the review of the chapter.
31
Revisiting the Learning Objectives II
LO16-2 Discuss how an unemployment-inflation trade-off arises.
Because the AS curve slopes upward, there is a trade-off between unemployment and inflation as illustrated by the Phillips curve.
The Phillips curve and the AS curve are mirror images.
The inflationary flashpoint is the rate of output where inflation accelerates and the trade-off becomes acute.
16-32
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Revisiting the Learning Objectives III
LO16-3 How shifts of the aggregate supply curve affect macro outcomes.
Supply-side policies attempt to shift AS to the right, yielding less inflation and less unemployment.
Marginal tax rates are a major concern of supply-side economists. They believe high tax rates discourage extra work, investment, and saving shifting the AS curve to the left.
16-33
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Revisiting the Learning Objectives IV
LO16- 4 Identify the tools of supply-side policy.
The goal of any supply-side policy should be to shift AS to the right.
A reduction in marginal tax rates will do this.
Also, a rightward shift of AS is the result of investments in human capital, reduction of regulatory costs, infrastructure development, and reduction of trade barriers.
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Looking Ahead: Chapter 17
Growth and Productivity: Long-Run Possibilities
After learning about this chapter, you should know:
The principal sources of economic growth.
The policy tools for accelerating growth.
The pros and cons of continued growth.
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