The Supply-Side Model and the New Economy Chapter 10 Chapter 10

 By the early 1980s, Keynesian discretionary demand-side stabilization policies were no longer effective.  The output-inflation (Phillips curve) trade-off no longer in evidence.  Birth of the Rational expectations School of macroeconomics. A new paradigm!  Hallmarks of this school of thought: Greater role of expectationGreater role of expectation UncertaintyUncertainty Asymmetric information.Asymmetric information. This was helped by more advanced and sophisticated time-series analyses. This was helped by more advanced and sophisticated time-series analyses.

Crucial assumption: Information is asymmetric. By assumption, employers know the changes in cotemporaneous prices and nominal wages but workers do not know these changes in P and W in the current period. Causes of the so-called demise of Keynesian macroeconomics: Expectations-augmented AS curve

(Fig. 10.1) (Fig. 10.1) 1. Assume the economy is at P 0,Y 0 in the (P,Y) space and assume P 0 =2. 2. As a result of a demand-side stabilization policy, AD 0 shifts right to AD 1. This causes P to increase to P 1 (from 2 to 5), and W 0 increases to W 1 (from 12 to 15). 3. Since information is asymmetric, employers know that prices have increased by more than 100% but workers see only the rise in their nominal wages (from 12 to 15). 4. The asymmetry of information leads to more demand for labor (since the real wage is lower) but workers think they are better off and supply more labor. 5. As a result, employment increases to n As a result of n increasing, Y increases to Y We link the points (P 1,Y 1 ) and (P 0,Y 0 ) to obtain the adaptive expectations AS curve (AE-AS).

An Expectations-Augmented Explanation of the Paradigm Shift Do workers misinterpret observed changes in nominal wage as changes in real wage only in the short and medium term? (Fig. 10.2) The last point covered in Fig 10.1 (point 7) is our starting point in Fig The last point covered in Fig 10.1 (point 7) is our starting point in Fig We note that the positively sloped AE-AS curve facilitates the output-inflation tradeoffs. We note that the positively sloped AE-AS curve facilitates the output-inflation tradeoffs.

 Eventually, workers catch on and realize that real wages are going down. They then update their expectations and when another round of expansionary fiscal or monetary stabilization is anticipated they indulge in pro-active long-term contracts (require that W=30 so that real wage remains 6). Information has become symmetric! Employment equilibrium is back at n 0 ; with Y = Y 0 but P = P 1.  We link the points (P 1,Y 0 ) and (P 0,Y 0 ) to obtain the rational expectations AS curve (RE-AS). Note that the RE-AS curve is vertical! This is the theoretical center piece of the new supply-side paradigm.  The RE-AS is also known as the new classical AS curve.

How can an economy move from the positively sloped AE-AS curve to the vertical RE-AS curve? Two requirements: 1. Sophisticated labor markets where market power can influence long-term labor contracts. 2. Fully articulated and efficient bond markets.

Shifting the AS curve  According to this new paradigm, shifting AD affects only the price level (P).  To increase GDP growth, the only viable option is to shift the AS to the right (supply-side model).  The main elements of supply-side economics are: 1. Significant income/personal tax cuts. 2. Extensive corporate/business tax cuts. 3. Substantial deregulation

Shifting the AS curve Significant income/personal tax cuts Labor Supply = f(real wage, personal tax rates, macro outlook) (+) (-) (+) (+) (-) (+)  Workers generally perceive tax cuts as temporary so they work More hours. Others see the incentive of joining the labor force. The labor supply curve shifts to the right. Tax rate increases shift the labor supply curve to the left.  Another explanation (Fig. 10.4): An increase in the tax rate (t) requires an increase in real wage (to keep employment at n 0 ) which results in an upward shift (left) in the labor supply curve (Fig, 10.4a).  In the rational expectations paradigm, taxes also influence the labor market (not just disposable income and consumption).

Shifting the AS curve Extensive corporate/business tax cuts Extensive corporate/business tax cuts Labor Demand = f(real wage, business tax rates, macro outlook) Labor Demand = f(real wage, business tax rates, macro outlook) (-) (-) (+) (-) (-) (+)  Cuts in corporate/business taxes cause the labor demand curve to shift to the right (Fig. 10.5). Deregulation  Increases innovation and productivity (Fig. 10.6).

Supply-Side Stabilization Incorporating the three major supply-side policies Incorporating the three major supply-side policies (Fig. 10.7). (Fig. 10.7). 1. We start from a low recessionary GDP growth rate (Y 0 ) with RE-AS. Assume there is asymmetric information. 2. Combining personal and business tax cuts with substantial deregulation causes the RE-AS curve to shift to the right. 3. We have higher Y (higher production function), higher n (both supply and demand of labor shift to the right) and lower price level!  A supply-side story: Ireland and IT.

Stagflation Raising inflation and falling rates of employment and GDP growth (Fig. 10.8). The 1970s oil shocks and stagflation in the U.S., Western Europe and Japan. The 1970s oil shocks and stagflation in the U.S., Western Europe and Japan. Late 2008: Rising prices and slowing growth. Late 2008: Rising prices and slowing growth.

The New Economy  Traces its roots to the supply-side policies implemented in the early 1980s.  Deregulation fostered technological progress and led to an upward shift in the production function.  Strong macroeconomic outlook caused labor demand and supply curves to shift to the right. So the equilibrium employment increased.  The RE-AS curve shifted to the right.  Hallmark of the New Economy: GDP growth without higher inflation. Mid 1990s-2000: U.S. average quarterly GDP growth rate was 5% and unemployment was in the 3% range, with no significant increases in the rate of inflation. Mid 1990s-2000: U.S. average quarterly GDP growth rate was 5% and unemployment was in the 3% range, with no significant increases in the rate of inflation.  The New Economy and the productivity puzzle.

The Identification Problem (Fig. 10.9)  Oxford Dictionary of Economics definition: “The problem of estimating the parameters of structural equations when all that can be observed is equilibrium positions. For example, in the market for a particular good, if demand conditions vary and supply conditions do not, comparing prices and quantities at different times allows us to determine the supply equation. If supply conditions vary and demand conditions do not, we can estimate the demand equation. But if both supply and demand conditions vary, regressing quantity on price tells us nothing. The identification problem can be resolved only if either theory or the results of other studies inform us that some explanatory variables affect one side of the market but not the other.”

A Keynesian Explanation of the New Economy  Keynesians argue that all AS curves (no matter their shape) will shift to the right if the production curve shifts upward as a result of higher labor productivity.  Fig a shows that even a Keynesian AS curve shifts to the right as a result of higher productivity and will lead to the same results (New Economy results, Fig b).

The New Economy Compared to the ‘Old Economy’  The old or traditional economy: Keynesian AS.  The New economy: (vertical AS) supply side See Table 10.1

Reconciling the Two Models  In the developed economies: In the long-run reconciliation will be highly unlikely.  Possibility of a quasi-paradigm. A transition from the short-run AS curve to a long-run supply-side model. This implies that in the short-run there is room for demand-side stabilization policies. This implies that in the short-run there is room for demand-side stabilization policies.  Robert Lucas and the ‘Islands’ economy

 The outlook for the New Economy  Which model can consistently explain all macroeconomic behavior in the developed economy?  Discussion: Article 10.2