Macroeconomics Unit 16 Supply-Side Policy and Short-Run Economic Options The Top Five Concepts

Introduction This unit discusses methods to achieve economic growth in the short-run. You are also introduced to supply-side theory and its application to the aggregate supply curve. If supply is not changed along with demand, there is a tradeoff between inflation and unemployment. With demand side changes, as unemployment is reduced inflation occurs; if inflation is reduced unemployment increases. Supply-side theory also contains incentives to boost aggregate demand.

Concept 1: Aggregate Supply In prior chapters we have examined policies designed to affect aggregate demand. Fiscal (Keynesian) and Monetary policies both focus on aggregate demand. Changing aggregate demand alone causes price changes which may not be desirable. Shifting aggregate supply alone and/or with shifts in aggregate demand may provide a better economic outcome. This is Supply-Side Theory.

Concept 1: Aggregate Supply Supply-side theories became popular in the late 1970s and early 1980s as a result of the economic conditions at that time. In the mid 1970s we had an inflation rate of 12.3% and an increase in unemployment to 5.6%. Also in the late 1970s and early 1980s we had excessive inflation and high unemployment causing stagflation. Stagflation occurs when both unemployment and inflation rise significantly together.

Concept 1: Aggregate Supply Keynes believed that the aggregate supply curve is horizontal until full employment is reached, then it becomes vertical. If that’s true, then rightward shifts in aggregate demand do not produce an increase in price if output is below the economy’s capacity to produce. Once aggregate demand reaches the full capacity of the economy, further increases in demand will cause prices to rise without a corresponding increase in supply.

Concept 1: Aggregate Supply Monetarists believe that the aggregate supply curve is vertical in the long run. Changes in the money supply can cause aggregate demand to shift, but aggregate supply remains fixed over all levels of output. Prices will change as aggregate demand shifts. Aggregate supply remains fixed at the long-run natural rate of unemployment according to Monetarists.

Concept 1: Aggregate Supply The consensus (and perhaps logical) view is that the aggregate supply curve starts out horizontally and becomes vertical at high levels of output. The middle portion of the supply curve has an upward slope. Changes in demand within the middle portion of the AS curve lead to price changes. Price changes cause fiscal and monetary policy to be less effective.

The Consensus View of Aggregate Supply OUTPUT (real GDP per period) PRICE LEVEL ( average price per unit) AS AD 1 AD Keynesian segment Monetarist segment Q6Q6 Q7Q7 Unemployment declining Inflation accelerating

Concept 2: Phillips Curve The implication associated with the consensus view is that policies designed to shift aggregate demand alone will never be completely effective. Inflation or unemployment will result if demand-side policies are used alone. The tradeoff between unemployment and inflation is expressed by the Phillips Curve.

Concept 2: Phillips Curve The Phillips curve is an inverse relationship between the rate of unemployment and the rate of inflation. When one increases the other decreases. This relationship was first recognized in the U.S. during the first half of the 20 th century, especially during the time period after World War II. Unemployment of 8% produced inflation of 4%. When either one when up, the other fell. For example, if unemployment was reduced to 4%, inflation increased to 8%.

The Phillips Curve Unemployment Rate (percent) Inflation Rate (percent) At any point on the curve, there is an inverse relationship between unemployment and inflation. As you move down the curve, unemployment increases and inflation decreases.

Concept 3: Shifting the AS Curve During the 1990s our economy experienced significant growth without inflation. Unemployment and inflation remained at historic lows. At first this appears to contradict the Phillips curve. However, we also had a shift in AS to the right. What affect did this rightward shift of AS have on the Phillips curve?

Concept 3: Shifting the AS Curve When the AS curve shifts to the right, aggregate supply has increased. Increasing aggregate supply reduces prices and decreases unemployment. The rightward shift of the aggregate supply curve produces a leftward shift in the Phillips curve. When the Phillips curve shifts to the left, the tradeoff between inflation and unemployment is reduced. Simply put, prior to the curve shifting if unemployment was reduced by 4%, inflation may have increased by 3%. After the shift, if unemployment is reduced by 4%, inflation increases only 1%.

Aggregate Supply Shifting Right AS 1 E1E1 Output (real GDP per period) 0 Price Level ( average price per unit of output) AD AS 2 E2E2 Rightward shifts of AS reduces unemployment and inflation

Unemployment Rate (percent) Inflation Rate (percent) Phillips Curve Shift 4 2 PC 2 PC 1 6 When AS shifts to the right, the Phillips Curve shifts left, reducing the tradeoff between inflation and unemployment.

Concept 4: Shifts of Aggregate Supply Okun developed an index that measures the effects of both inflation and unemployment changing together (stagflation). The index is called the Misery index. The Misery index adds together the unemployment and inflation rates. For example, if inflation is 5% and unemployment is 6%, the Misery index is 11%.

Concept 4: Shifts of Aggregate Supply The Misery index indicates the level of economic distress experienced within the economy caused by stagflation Generally, an index of 6 or less is not considered to be a concern. Higher levels, like those experienced during the time Reagan was first elected president (Misery Index = 19.6, with 12.5% inflation, and 7.1% unemployment), are considered harmful to the economy. President Reagan’s economic policies successfully reduced inflation and unemployment which reduced the misery index although budget deficits increased.

Concept 5: Supply-side Policy The purpose of supply-side policy is to shift AS to the right. Anytime AS shifts to the left, output declines and prices rise. Leftward AS shifts are usually caused by external shocks (natural disasters, OPEC oil supply reductions, Sept. 11 attacks, etc.). They can also be caused by increased government regulation and marginal tax rate increases. There are four main policy levers that can be used to shift AS to the right. These are the basis of supply-side theory.

Concept 5: Supply-side Policy Tax Incentives for saving, investment, and work. Human capital investment. Deregulation. Infrastructure development. Let’s look at each one…

Tax Incentives Tax cuts are a popular tool used on the demand-side to stimulate AD. Tax cuts on the supply-side are focused on the marginal tax rate. The marginal tax rate is the tax rate imposed on the last dollar of income. This could be the tax on individuals working overtime, people in the highest tax bracket, or the taxes a corporation pays if its output increases.

Tax Incentives High tax rates discourage investment by corporations as well as discourage workers from working overtime or seeking higher paying jobs. Tax cuts to stimulate the economy on the supply-side are designed to reduce marginal tax rates. If marginal tax rates are reduced, workers have a greater incentive to work harder and longer hours. Marginal tax rate reductions also encourage companies to expand output and investment.

Tax Incentives The effectiveness of tax cuts can be measured by looking at the tax elasticity of supply. The tax elasticity of supply measures the percentage change in the quantity of labor or capital supplied, divided by the percentage change in tax rates. Tax elasticity of supply (E) = % change in quantity supplied / % change in tax rate The value (E) provides us with an indication of how consumers or businesses will respond to a tax cut.

Tax Incentives E is usually expressed as an absolute value (not negative). For example, if E = 1.5, a 10% corporate tax cut would lead to a 15% increase in output (1.5 X 10%). If E =.5, then a 20% individual tax cut would lead to a 10% increase in worker output (.5 X 20%). The higher the value of E, the greater the increase in output that can be achieved from a tax cut.

Tax Incentives Savings incentives are also an important part of any tax package. Demand-side policies treat savings as a leakage from the circular flow. Supply-side policies believe savings is an important future component of investment and growth. Supply-side policies that provide tax incentives for savings and investment can eventually shift AS rightward.

Tax Incentives Individual savings incentives consist of IRAs, 401Ks, reducing taxes on interest earned, and possibly reducing capital gains taxes. Investment savings incentives consist of capital gains tax reductions, investment tax credits, and Economic Renaissance Zones which provide special tax and accounting incentives for business to develop and expand in underdeveloped or abandoned areas.

Human Capital Investment Human capital is the knowledge and skills possessed by the work force. An investment in human capital could consist of finishing high school, attending college or a trade school, in-house training, and management training. Human capital investment increases the quality and ability of the workforce.

Human Capital Investment Human capital investment reduces structural unemployment which is the mismatch between worker skills and jobs available. Human capital investment improves labor productivity – leads to higher output per worker. Welfare programs that provide incentives for individuals to seek training and return to the workforce also are human capital investments.

Human Capital Investment Tax incentives for business to provide additional training or educational assistance to employees can help increase human capital investment. Tax incentives directed at individuals can also provide incentives to help individuals increase their skills and abilities (tuition deductions, etc.). The investment in human capital has one long term goal: to shift AS to the right.

Deregulation Deregulation is the reduction or elimination of government rules or standards which do not serve a useful purpose. Most government regulation increases employer costs – some are necessary but others may be outdated or have high compliance costs. Minimum wages, mandatory benefits (FMLA), OSHA compliance, FDA standards, and EPA requirements are examples of regulation.

Deregulation - Trade Barriers U.S. regulation of foreign trade, combined with foreign government regulation, can affect AS. Quotas and tariffs on imported goods reduces output or increases the costs of production. Foreign markets that restrict U.S. imports or impose tariffs reduces our ability to sell in foreign markets. If quotas or tariffs are eliminated, increased production can occur which shifts AS to the right.

Infrastructure Development Infrastructure is the transportation, communication, education, judicial, and other systems that assist market exchanges. An investment in infrastructure means you are improving it. Widening highways, improving communications using fiber optic or satellite technology, and expanding airports are examples.

Infrastructure Subsidies or scholarships to attend college or build new facilities, and adding judges improves infrastructure. Improving the infrastructure shifts AS to the right, and because of the spending activity on infrastructure, it will also shift AD to the right.

Expectations We have learned that expectations are a determinant of demand. Consumer expectations affect the demand curve. Expectations also affect the supply curve. Business investment to increase output is dependent upon their view of the future. If businesses expect better economic and political conditions, investment will increase and AS shifts to the right. If businesses are concerned about future economic and/or political conditions, investment will likely decline.

Summary Stagflation. Phillips curve. Keynesian, Monetarist, Consensus views. Understand the misery index. Rightward and leftward shifts of the aggregate supply curve. Policy levers for shifting aggregate supply. Marginal tax rate. Tax elasticity of supply and what the value of E indicates. Human capital investment. Deregulation. International trade. Infrastructure. Expectations.