1. McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Supply-Side Policy: Short-Run Options Chapter 16

2. 2 Aggregate Supply The macro economy experienced stagflation in the 1970s. Stagflation is the simultaneous occurrence of substantial unemployment and inflation.

3. 3 Aggregate Supply Shifts of the aggregate demand curve can’t increase inflation and unemployment at the same time. The shape and shifts in aggregate supply hold the clues on how stagflation may occur. LO1

4. 4 Aggregate Supply Aggregate supply is the total quantity of output that producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus. LO1

5. 5 Shape of the AS Curve The response of producers to an AD shift is expressed in the slope and position of the AS curve. LO1

6. 6 Three Views of AS There are three views concerning the shape of the aggregate supply curve. Keynesian Monetarist Hybrid LO1

7. 7 Keynesian AS AS is horizontal up to full employment. At this point, AS becomes vertical. LO1

8. 8 PRICE LEVEL (average price per unit of output) OUTPUT (real GDP per period) Keynesian AS Aggregate supply AD 3 AD 2 AD 1 Q1Q1 Q* P 1 LO1

9. 9 Monetarist AS AS is vertical and located at full employment. LO1

10. 10 Monetarist AS OUTPUT (real GDP per period) PRICE LEVEL (average price per unit of output) QNQN AD 4 AD 5 P4P4 P5P5 Aggregate supply LO1

11. 11 Hybrid AS As 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. LO1

12. 12 OUTPUT (real GDP per period) PRICE LEVEL (average price per unit of output) Hybrid AS AS AD 7 AD 6 Keynesian segment Monetarist segment Q6Q6 Q7Q7 Unemployment declining Inflation accelerating LO1

13. 13 The Inflation-Unemployment Tradeoff The economy cannot reduce both unemployment and inflation at the same time – at least not with fiscal and monetary policies. LO2

14. 14 Demand Stimulus Because the aggregate supply curve is upward-sloping, rightward shifts of the aggregate demand curve increase both prices and output. LO2

15. 15 Demand Restraint If the aggregate supply curve is upward-sloping, leftward shifts of the aggregate demand curve cause both prices and output to fall. LO2

16. 16 The Phillips Curve The Phillips curve is a historical and inverse relationship between the rate of unemployment and the rate of inflation. Commonly expressed as a tradeoff between the two. LO2

17. 17 The Phillips Curve 01234567 11 10 9 8 7 6 5 4 3 2 1 Unemployment Rate (percent) Inflation Rate (percent) B A C LO2

18. 18 The Phillips Curve Trade-Off UNEMPLOYMENT RATE INFLATION RATE A trade-off between unemployment and inflation. REAL OUTPUT PRICE LEVEL Increases in aggregate demand causes..... Aggregate supply B C AD 1 AD 2 A AD 3 Phillips curve c b a LO2

19. 19 Shifts of the AS Curve Many economists argue that the economy can attain lower levels of unemployment without higher inflation.

20. 20 Rightward AS Curve Shifts: All Good News Only a rightward shift of the AS curve can reduce unemployment and inflation at the same time.

21. 21 Output (real GDP per period) 0 Price Level (average price per unit of output) Shifts of Aggregate Supply AS 1 E1E1 AD AS 2 E2E2 Rightward AS shifts reduce unemployment and inflation

22. 22 Phillips Curve Shift The Phillips curve shifts when the AS curve shifts. The unemployment-inflation trade-off eases when the Phillips curve shifts to the left.

23. 23 12345678 Unemployment Rate (percent) Inflation Rate (percent) Phillips Curve Shift 4 2 a b PC 2 PC 1 Rightward AS shifts cause leftward Phillips curve shifts

24. 24 The Misery Index The misery index is the sum of the inflation and unemployment rates.

25. 25 The Misery Index

26. 26 Leftward AS Shifts: All Bad News Leftward AS shifts create stagflation. Supply-side shocks can shift the AS curve to the left. Leftward shifts of aggregate supply are less dramatic in a large economy like the U.S.

27. 27 Policy Tools Rightward shifts of the aggregate supply curve always generate desirable macro outcomes. LO3

28. 28 Shifts of Aggregate Supply The AS curve can shift rightward through: Tax incentives for saving, investment and work. Human capital investment. Deregulation. Trade liberalization. Infrastructure development. LO3

29. 29 Two Theories for Getting the Economy Moving 1 Cut tax rates to boost incentives to work and invest. 1 Cut tax rates to put more disposable income in people’s hands. 2 People use increased income to buy more goods and services: aggregate demand increases. 2 Firms invest more and try new ventures; jobs are created; people work harder aggregate supply increases. 3 New investment and labor bring increased output. 3 To meet new demand, companies expand output. 4 Employment rises, new plants go up, the whole economy expands. Supply-Side TheoryKeynesian Theory LO3

30. 30 Tax Incentives In Keynesian economics, tax cuts are used to increase aggregate demand. The direct effects of taxes on the supply of goods are the concern of supply-side economists. LO3

31. 31 Marginal Tax Rates Supply-side theory places special emphasis on marginal tax rates. Marginal Tax Rate - The tax rate imposed on the last (marginal) dollar of income. LO3

32. 32 Changes in Marginal Tax Rates Since 1915 LO3

33. 33 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. LO3

34. 34 Entrepreneurship High progressive tax rates discourage entry into self- employment. LO3

35. 35 Investment Aggregate supply will be constrained if high tax rates discourage investment. Investment – Expenditures on (production of) new plant, equipment, and structures (capital) in a given time period, plus changes in business inventories. LO3

36. 36 Tax-Induced Supply Shifts A reduction in marginal tax rates shifts the aggregate supply curve to the right. Work effort, entrepreneurship, and investment increase. LO3

37. 37 Tax-Induced Supply Shifts Tax rebates do not shift AS because they are one-time windfall and have no effect on marginal tax rates. A tax rebate is a lump-sum refund of taxes paid. LO3

38. 38 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. LO3

39. 39 The Tax Elasticity of Supply If the tax elasticity of supply were large enough, a tax cut might actually increase tax revenues. LO3

40. 40 Savings Incentives Supply-side economists favor tax incentives that encourage saving as well as greater tax incentives for investment. Saving is that part of disposable income not spent on current consumption. It is disposable income less consumption. LO3

41. 41 Investment Incentives Tax incentives for investment are an alternative lever for shifting aggregate supply. Examples include cutting capital gains tax rates and investment tax credits. LO3

42. 42 Human Capital Investment Human capital is the knowledge and skills possessed by the work force. The ability to supply goods and services depends on its human capital as well as its physical capital. LO3

43. 43 Structural Unemployment. Investments in human capital reduce structural employment and shift the aggregate supply curve rightward. Structural unemployment is the unemployment caused by a mismatch between the skills (or location) of job seekers and the requirements (or location) of available jobs. LO3

44. 44 Worker Training Tax incentives to businesses that offer worker training is a viable policy tool for future shift in aggregate supply. Labor productivity is the amount of output produced by a worker in a given period of time. Measured as output per hour (or day, etc.). LO3

45. 45 Education Spending Expanding and improving the efficacy of the education system will increase human capital. Education spending is more likely to develop human capital gradually rather than to spur short-term economic growth. LO3

46. 46 Affirmative Action Race and gender issues (as opposed to lack of skills and experience) can create artificial barriers between job seekers and job openings. LO3

47. 47 Transfer Payments Transfer programs, such as welfare programs can discourage workers from taking jobs. Transfer payments are payments to individuals for which no current goods or services are exchanged, such as social security, welfare, unemployment benefits. LO3

48. 48 Deregulation The added costs of production due to regulation shift the aggregate supply curve to the left. LO3

49. 49 Factor Markets Government intervention in factor markets raises the cost of supplying goods and services in many ways. LO3

50. 50 Minimum Wage In the absence of a minimum wage, employers would hire and train more workers. Minimum-wage laws shift the aggregate supply curve leftward, making it more difficult to achieve full employment with stable prices. LO3

51. 51 Mandatory Benefits By requiring employers to provide specific fringe benefits, the government increases the cost of doing business. The higher costs shift the aggregate supply curve leftward. LO3

52. 52 Occupational Health and Safety OSHA, the Occupational Health and Safety Administration, forces employers to conform to certain minimum safety conditions at workplaces. The additional costs shift the aggregate supply curve to the left. LO3

53. 53 Product Markets Government regulations raise costs in product markets. LO3

54. 54 Transportation Costs The regulation of transportation costs constrains the ability of producers to respond to increases in demand and prevents new producers from entering the market. LO3

55. 55 Food and Drug Standards The Food and Drug Administration causes companies to incur additional costs as they must ensure their product(s) conform to FDA standards. LO3

56. 56 Reducing Costs 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. LO3

57. 57 Easing Trade Barriers Government regulation of international trade affects aggregate supply. LO3

58. 58 Factor Markets Reducing tariffs or quotas on imports of production inputs decrease production costs and increase aggregate supply. LO3

59. 59 Product Markets Foreign-produced goods increase the quantity of output available at any given price level. Free trade pacts like the North American Free Trade Agreement (NAFTA) tend to shift aggregate supply rightward. LO3

60. 60 Immigration Immigration of foreign-born workers can increase the pool of skilled labor, shifting the aggregate supply curve to the right. LO3

61. 61 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. LO3

62. 62 Expectations Because investment is always a bet on future economic conditions, expectations directly affect the shape of the AS curve. LO3

63. 63 Rebuilding America The output of the American economy depends not only on private investment, but on public investment as well. LO3

64. 64 Declining Infrastructure Investment Like private capital, public capital contributes to our production possibilities. Declining infrastructure investment reduces actual and potential output. The transportation system isn’t keeping up with a growing economy. LO3

65. 65 The Cost of Delay Delays in infrastructure investment only worsens the situation. LO3

66. 66 The Rebuilding Process If spent wisely, infrastructure improvements will increase aggregate supply.

67. McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Supply-Side Policy: Short-Run Options End of Chapter 16