Chapter 16: Supply-Side Policy: Short-Run Options McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. 13e

16-2 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.

16-3 Learning Objectives Explain why the short-run AS curve shifts upward Discuss how an unemployment- inflation trade-off arises Identify the tools of supply-side policy.

16-4 Aggregate Supply In the 1970s, stagflation occurred. – 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.

16-5 Shape of the AS Curve Each policy school in economics has an opinion about what the AS curve looks like. Keynesians: – AS is horizontal. – 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.

16-6 Shape of the AS Curve Each policy school in economics has an opinion about what the AS curve looks like. Monetarists: – 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.

16-7 Shape of the AS Curve Each policy school in economics has an opinion about what the AS curve looks like. 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.

16-8 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 we are, the greater the risk that fiscal or monetary stimulus will spill over into inflation.

16-9 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. – There is an inflation-unemployment trade-off, which is expressed in the Phillips curve.

16-10 The Phillips Curve Trade-Off 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.

16-11 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.

16-12 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.

16-13 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.

16-14 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.

16-15 What Shifts the AS Curve? 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.

16-16 Tax Incentives Keynesians cut taxes to increase AD. Supply-siders note that high tax rates destroy the incentive to work and produce, which ends up reducing output. Low tax rates encourage people to earn more because more ends up in disposable income and less goes to the government.

16-17 Tax Incentives 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 Earn more. Start or expand a business. Increase investment spending.

16-18 Tax Incentives 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.

16-19 Savings Incentives Keynesians treat saving as a leakage to the circular flow, because they emphasize spending. 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.

16-20 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.

16-21 Human Capital Investment Human capital: the knowledge and skills possessed by the workforce. Supply-siders encourage investments in human capital 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.

16-22 Other Human Capital Incentives Supply-siders want to increase human capital by expanding and improving the educational system. Affirmative action programs are designed to reduce discriminatory barriers, which will shift AS to the right. Transfer payments can become excessive and provide a disincentive for recipients to take a job. Welfare reforms in 1996 had a positive supply-side impact and kept basic welfare programs intact.

16-23 Deregulation When government sets rules 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.

16-24 Deregulation Government interventions that have good reasons for existing but shift AS to the left by increasing costs to producers. – 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.

16-25 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. By advocating the reduction of tariffs on inputs and improvement in the flow of immigrant workers, supply-siders note that production costs fall and AS shifts right.

16-26 Infrastructure Development 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.

16-27 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.