1. SUPPLY-SIDE POLICY Eva Hromádková, 26.4 2010 Macroeconomics ECO 110/1, AAU Lecture 10

2. 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? 2

3. Aggregate Supply Motivation 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. 3

4. Aggregate Supply Shape 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 LO1 4

5. Aggregate Supply Keynesian 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 LO1 5

6. 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. LO1 6

7. 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. LO1 7

8. Aggregate Supply The 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. LO2 8

9. Aggregate Supply The Inflation-Unemployment Tradeoff - Illustration 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 9

10. Aggregate Supply The 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 LO2 10

11. Aggregate Supply The Phillips curve - UK LO2 11 The Phillips curve in the UK, 1861 - 1913

12. Aggregate Supply The Phillips curve - USA LO2 12 The Phillips curve in the US, 1961 - 1969

13. Aggregate Supply Shifts 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) 13

14. Output (real GDP per period) 0 Price Level (average price per unit of output) Aggregate Supply Rightward shift of the AS curve AS 1 E1E1 AD AS 2 E2E2 Rightward AS shifts reduce unemployment and inflation 14

15. 12345678 Unemployment Rate (percent) Inflation Rate (percent) Aggregate Supply Rightward shift of the AS curve – Shift of Phillips curve 4 2 a b PC 2 PC 1 Rightward AS shifts cause leftward Phillips curve shifts 15

16. Aggregate Supply Policy 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. LO3 16

17. 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 17

18. Supply-Side Policies 1. 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 LO3 18

19. Supply-Side Policies 1. 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 LO3 19

20. 1. Tax Incentives Tax systems in our countries LO3 20 CorporatePersonalPayroll Austria25%21-50% Belarus24%12%35% China25%5-45% Czech Rep21%15%47.5% Georgia15%20% Kazakhstan17.5%10%11% Macedonia Nigeria Russia13-20%13%10-26% Slovak Rep19% USA15-39% (fed) 0-12% (state) 0-35%(fed) 0-10.3% 15.3%, 2.9% (regressive) Ukraine25%15% Uzbekistan12%13-30%

21. 1. Tax Incentives Effects 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. LO3 21

22. 1. Tax Incentives Computational Problem #1: 22 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?

23. 1. Tax Incentives Tax-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. LO3 23

24. 1. Tax Incentives Quantification 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 LO3 24

25. 1. Tax Incentives Computational Problem #2: 25 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?

26. 1. Tax Incentives Savings 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 LO3 26

27. 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 LO3 27

28. 2. Human Capital Investment A. 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 LO3 28

29. 2. Human Capital Investment B. 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. LO3 29

30. 2. Human Capital Investment C. 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? LO3 30

31. 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. LO3 31

32. 3. Deregulation A. 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 LO3 32

33. 3. Deregulation B. 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) LO3 33

34. 3. Deregulation Summary  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 LO3 34

35. 4. Easing Trade Barriers A. 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? LO3 35

36. 4. Easing Trade Barriers B. 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 LO3 36

37. 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? LO3 37