SUPPLY-SIDE POLICY
Eva Hromádková, 26.4 2010
Macroeconomics ECO 110/1, AAULecture 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 SupplyMotivation 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 SupplyShape 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 SupplyKeynesian 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 SupplyThe 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 SupplyThe Inflation-Unemployment Tradeoff - Illustration
UNEMPLOYMENT RATE
INF
LAT
ION
RA
TE
A trade-off between unemployment and inflation.
REAL OUTPUT
PR
ICE
LE
VE
L
Increases in aggregate demand causes . . . . .
Aggregatesupply
B
C
AD1
AD2AAD3
Phillips curve
c
b
a
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Aggregate SupplyThe 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 SupplyThe Phillips curve - UK
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The Phillips curve in the UK, 1861 - 1913
Aggregate SupplyThe Phillips curve - USA
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The Phillips curve in the US, 1961 - 1969
Aggregate SupplyShifts 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
Pri
ce L
eve
l(a
vera
ge
pric
e p
er
unit
of o
utp
ut)
Aggregate SupplyRightward 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 8Unemployment Rate (percent)
Infla
tion
Ra
te (
pe
rce
nt)
Aggregate SupplyRightward shift of the AS curve – Shift of Phillips curve
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2
a
b
PC2
PC1 Rightward AS shifts cause leftward Phillips curve shifts
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Aggregate SupplyPolicy 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
1Cut tax rates to boost incentives to
work and invest.
1Cut tax rates to put more
disposable income in people’s hands.
2People use increased income to buy more goods and services:aggregate demand increases.
2Firms invest more and try new
ventures; jobs are created; people work harder aggregate
supply increases.
3New investment and labor
bring increased output.
3To meet new demand, companies
expand output.
4 Employment rises, new plants go up,
the whole economy expands.
Supply-Side Theory Keynesian Theory
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Supply-Side Policies1. 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 Policies1. 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 IncentivesTax systems in our countries
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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 IncentivesEffects
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 IncentivesComputational 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 IncentivesTax-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 IncentivesQuantification 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 IncentivesComputational 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 IncentivesSavings 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 InvestmentA. 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 InvestmentB. 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 InvestmentC. 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. DeregulationA. 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. DeregulationB. 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. DeregulationSummary
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 BarriersA. 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 BarriersB. 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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