SUPPLY-SIDE POLICY
Eva Hromádková, 26.4 2010
Macroeconomics ECO 110/1, AAU Lecture 10
Overview
How does aggregate supply affect outcomes of the economy?
The best of both worlds: low inflation & low unempl.
How can we shift AS curve?
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Aggregate Supply
Motivation for supply-side policies
In the 1970’s, the US economy has
experienced stagflation = simultaneous
occurrence of substantial unemployment and inflation.
Cannot be explained by changes in the aggregate demand (Q: why? – explanation = slide 8)
Alternative explanation was sought
What about other side of market = production?
Aggregate supply = total quantity of output
that producers are willing and able to supply at alternative price levels in a given time period.
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Aggregate Supply
Shape of the AS curve
The response of producers to an AD shift is expressed in the slope and position of the AS curve.
If economy increases demand, will they produce more or charge higher prices?
There are three views concerning the shape of the aggregate supply curve.
Keynesian – very short term
Monetarist – very long term
Hybrid
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Aggregate Supply
Keynesian AS
AS is horizontal up to full employment.
=> Producers increase
output, not prices, when AD expanded
At the full
employment, AS becomes vertical.
=> At full capacity they cannot produce more, even if they are paid lot
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Aggregate Supply
Monetarist AS
Producers make output decisions based on
fundamental factors = technology, market size, capital
Change in price of output
= change in costs of input (no change in output level)
AS is vertical and located at full
employment.
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Aggregate Supply
Hybrid AS
At low rates of
unemployment AS is horizontal and at high rates of unemployment AS is nearly vertical.
In between, AS is
gently upward sloping.
The closer to capacity, the greater the risk
that fiscal or monetary stimulus will spill over into price inflation.
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Aggregate Supply
The Inflation-Unemployment Tradeoff
Demand-side policies (fiscal and monetary) cannot reduce both unemployment and
inflation at the same.
Demand stimulus: as the AS curve is upward- sloping, rightward shifts of the aggregate
demand curve increase both prices and output.
Demand restraint: as the AS curve is upward- sloping, leftward shifts of the aggregate
demand curve cause both prices and output to fall.
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Aggregate Supply
The Inflation-Unemployment Tradeoff - Illustration
UNEMPLOYMENT RATE
INFLATION RATE
A trade-off between
unemployment and inflation.
REAL OUTPUT
PRICE LEVEL
Increases in aggregate demand causes . . .
Aggregate supply
B C
AD1 AD2 A
AD3
Phillips curve
c
b
a
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Aggregate Supply
The Phillips Curve
The Phillips curve = historical inverse relationship (tradeoff) between the rate of unemployment and the rate of
inflation.
A. W. Phillips: UK, years 1826-1957
Samuelson and Solow: USA, years 1900- 1960
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Aggregate Supply
The Phillips curve - UK
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The Phillips curve in the UK, 1861 - 1913
Aggregate Supply
The Phillips curve - USA
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The Phillips curve in the US, 1961 - 1969
Aggregate Supply
Shifts of the AS curve
Many economists argue that the economy can attain lower levels of unemployment without higher inflation.
rightward shift of the AS curve can reduce
unemployment and inflation at the same time
The Phillips curve shifts left, thus the unemployment- inflation trade-off eases
leftward AS shift creates stagflation (low output, rising prices)
Usually caused by supply-side shocks affecting both capital and labor force (hurricanes, tsunami) or
expectations (September 11, 2001)
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Output (real GDP per period) 0
Price Level (average price per unit of output)
Aggregate Supply
Rightward shift of the AS curve
AS1
E1
AD AS2
E2 Rightward AS shifts reduce
unemployment and inflation
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1 2 3 4 5 6 7 8 Unemployment Rate (percent)
Inflation Rate (percent)
Aggregate Supply
Rightward shift of the AS curve – Shift of Phillips curve
4
2
a
b PC2
PC1 Rightward AS shifts cause leftward Phillips curve shifts
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Aggregate Supply
Policy tools
Rightward shifts of the aggregate supply curve always generate desirable macro outcomes.
The AS curve can shift rightward through:
1. Tax incentives for saving, investment and work.
2. Human capital investment.
3. Deregulation.
4. Trade liberalization.
5. Infrastructure development.
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Two Theories for Getting the Economy Moving
Cut tax rates to boost incentives to 1 work and invest.
Cut tax rates to put more 1 disposable income in people’s
hands.
People use increased income to 2 buy more goods and services:
aggregate demand increases.
Firms invest more and try new 2 ventures; jobs are created;
people work harder aggregate supply increases.
New investment and labor 3 bring increased output.
To meet new demand, companies 3 expand output.
Employment rises, new plants go up, 4 the whole economy expands.
Supply-Side Theory Keynesian Theory
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Supply-Side Policies
1. Tax Incentives
Keynesians: tax cuts are used to increase aggregate demand through increase in
disposable income.
Supply-side economy: analyses direct
effects of taxes on the incentives to work and produce
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Supply-Side Policies
1. Tax Incentives
Supply-side theory places special
emphasis on marginal tax rates = the tax rate imposed on the last (marginal) dollar of income.
Progressive tax: higher income => higher relative tax payment => increasing
marginal tax rate
Flat tax: constant marginal tax rate
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1. Tax Incentives
Tax systems in our countries
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20 Corporate Personal Payroll
Austria 25% 21-50%
Belarus 24% 12% 35%
China 25% 5-45%
Czech Rep 21% 15% 47.5%
Georgia 15% 20%
Kazakhstan 17.5% 10% 11%
Macedonia Nigeria
Russia 13-20% 13% 10-26%
Slovak Rep 19% 19%
USA 15-39% (fed) 0-12%
(state)
0-35%(fed)
0-10.3% 15.3%, 2.9%
(regressive)
Ukraine 25% 15%
Uzbekistan 12% 13-30%
1. Tax Incentives
Effects
Labor supply:
The marginal tax rate influences the financial incentive to increase one’s work.
If the marginal tax rate is high, there is less incentive to work.
Entrepreneurship:
High progressive tax rates discourage entry into self-employment.
Investment:
Aggregate supply will be constrained if high tax rates discourage investment.
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1. Tax Incentives
Computational Problem #1:
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Suppose taxpayers are required to pay a base tax $50 plus 50% on any income over $200. Suppose further that the taxing authority wishes to decrease by $30 the taxes of people with incomes of $300.
If the marginal tax rates are to remain unchanged, what will the new tax base be?
If the base tax of $50 is to remain unchanged, what will marginal tax rate have to be?
What are the implications of these tax changes in the view of Keynesian theory?
What are the implications of these tax changes in the view of supply-side theory?
1. Tax Incentives
Tax-Induced Supply Shifts
A reduction in marginal tax rates shifts the aggregate supply curve to the right.
Work effort, entrepreneurship, and investment increase.
Note: Tax rebates or lump sum
deductions do not shift AS because they are one-time windfall and have no effect on marginal tax rates.
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1. Tax Incentives
Quantification of effect: 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 (larger than 1), a tax cut might actually increase tax revenues.
Estimates of tax elasticity of supply: 0.15-0.2
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1. Tax Incentives
Computational Problem #2:
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Suppose households supply 150 billions hours of labor per year and have a tax
elasticity of supply of 0.25. If the tax rate
is increased by 5%, by how many hours
will the supply of labor decline?
1. Tax Incentives
Savings and Investments Incentives
Supply-side economists favor tax
incentives that encourage saving as well as greater tax incentives for investment.
Demand side – stimulate consumption not saving (due to multiplication effect)
Savings = source for investment and growth
Policies that encourage investment: cutting capital gains tax rates and investment tax credits
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2. Human Capital Investment
Human capital is the knowledge and skills possessed by the work force.
If the quality of work force increases, more output can be supplied at given price level
Structural unemployment – mismatch between skills and jobs requirements – major cause of unemployment – inflation trade-off
Firms cannot hire more workers – they raise prices
Thus, policies focused on decreasing structural unemployment shift AS curve to the right
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2. Human Capital Investment
A. Worker Training
Tax incentives to businesses that offer worker training is a viable policy tool for future shift in aggregate supply.
In the long run they increase labor productivity = the amount of output
produced by a worker in a given period of time.
Measured as output per hour (or day, etc.).
In the short run they impose additional labor costs
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2. Human Capital Investment
B. Education Spending
Expansion and improvement of the efficiency of the educational system => higher HC
Examples:
School vouchers
Q: Do you like the idea? Where do you see its strengths / weaknesses?
Increased gvt. spending on schools
Tax incentives for college savings accounts
Note: Education spending is more likely to develop human capital gradually rather than to spur short-term economic growth.
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2. Human Capital Investment
C. Reducing discriminatory barriers
Race and gender issues (as opposed to lack of
skills and experience) can create artificial barriers between job seekers and job openings.
Policies:
Affirmative action (positive discrimination)
Q: Yes/no? What is your opinion?
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2. Human Capital Investment
D. Transfer Payments
Transfer payments are payments to
individuals for which no current goods or services are exchanged, such as social
security, welfare, unemployment benefits.
On one hand side, they serve important social needs.
On the other, they can discourage workers from taking jobs.
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3. Deregulation
A. Factor markets
The added costs of production due to regulation shift the aggregate supply curve to the left.
Minimum wage:
Main goal: ensure a decent standard of living (CR 8000 CZK)
By-product: limits ability of employers to hire additional people
Mandatory benefits
Health benefits, leaves of absence
Occupational health and safety
minimum safety conditions at workplaces
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3. Deregulation
B. Product markets
Transportation costs :
E.g.: Regulation of truck traffic during weekends
Food and drug standards
Goal = minimize health risks to consumers
Approval of new drugs – long time and huge investment
Fewer new drugs are brought to market
They are more expensive
Efficiency x harmfulness (drug neither helps nor harms)
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3. Deregulation
Summary
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 .
Other opinion: regulation = price of externality
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4. Easing Trade Barriers
A. Factor and product markets
Government regulation of international trade affects aggregate supply
.
Factor markets: Tariffs, quotas and restrictions that make foreign inputs more expensive constrain
domestic AS
Product markets: Tariffs, quotas and restrictions that make foreign products more expensive constrain
domestic AS
Policies: WTO, NAFTA, EU – common market
Q1: What is the difference between tariff and quota?
Q2: Why do countries introduce these protectionist measures?
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4. Easing Trade Barriers
B. Immigration
Immigration of foreign-born workers can increase the pool of skilled labor, shifting the aggregate supply curve to the right.
Solution to low population growth?
Policies: green card initiatives (Canada, Australia, but also CR)
Dangers:
Brain drain
Second and third generation
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5.Infrastructure Development
Improving the nation’s infrastructure reduces the costs of supplying goods.
Infrastructure is the transportation,
communications, education, judicial, and other institutional systems that facilitate market
exchanges.
Q1: Would you say your country has an
adequate infrastructure? What is the main problem?
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