SUPPLY-SIDE POLICY

Eva Hromádková, 26.4 2010

Macroeconomics ECO 110/1, AAULecture 10

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?

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Aggregate SupplyMotivation 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.

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Aggregate SupplyShape 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

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Aggregate SupplyKeynesian 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

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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.

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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.

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Aggregate SupplyThe 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.

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Aggregate SupplyThe Inflation-Unemployment Tradeoff - Illustration

UNEMPLOYMENT RATE

INF

LAT

ION

RA

TE

A trade-off between unemployment and inflation.

REAL OUTPUT

PR

ICE

LE

VE

L

Increases in aggregate demand causes . . . . .

Aggregatesupply

B

C

AD1

AD2AAD3

Phillips curve

c

b

a

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Aggregate SupplyThe 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

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Aggregate SupplyThe Phillips curve - UK

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The Phillips curve in the UK, 1861 - 1913

Aggregate SupplyThe Phillips curve - USA

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The Phillips curve in the US, 1961 - 1969

Aggregate SupplyShifts 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)

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Output (real GDP per period) 0

Pri

ce L

eve

l(a

vera

ge

pric

e p

er

unit

of o

utp

ut)

Aggregate SupplyRightward shift of the AS curve

AS1

E1

AD

AS2

E2

Rightward AS shifts reduce unemployment and

inflation

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1 2 3 4 5 6 7 8Unemployment Rate (percent)

Infla

tion

Ra

te (

pe

rce

nt)

Aggregate SupplyRightward shift of the AS curve – Shift of Phillips curve

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2

a

b

PC2

PC1 Rightward AS shifts cause leftward Phillips curve shifts

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Aggregate SupplyPolicy 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.

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Two Theories for Getting the Economy Moving

1Cut tax rates to boost incentives to

work and invest.

1Cut tax rates to put more

disposable income in people’s hands.

2People use increased income to buy more goods and services:aggregate demand increases.

2Firms invest more and try new

ventures; jobs are created; people work harder aggregate

supply increases.

3New investment and labor

bring increased output.

3To meet new demand, companies

expand output.

4 Employment rises, new plants go up,

the whole economy expands.

Supply-Side Theory Keynesian Theory

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Supply-Side Policies1. 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

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Supply-Side Policies1. 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

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1. Tax IncentivesTax systems in our countries

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Austria 25% 21-50%

Belarus 24% 12% 35%

China 25% 5-45%

Czech Rep 21% 15% 47.5%

Georgia 15% 20%

Kazakhstan 17.5% 10% 11%

Macedonia

Nigeria

Russia 13-20% 13% 10-26%

Slovak Rep 19% 19%

USA 15-39% (fed)0-12% (state)

0-35%(fed)0-10.3%

15.3%, 2.9%(regressive)

Ukraine 25% 15%

Uzbekistan 12% 13-30%

1. Tax IncentivesEffects

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.

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1. Tax IncentivesComputational Problem #1:

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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?

1. Tax IncentivesTax-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.

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1. Tax IncentivesQuantification 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

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1. Tax IncentivesComputational Problem #2:

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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?

1. Tax IncentivesSavings 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

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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

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2. Human Capital InvestmentA. 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

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2. Human Capital InvestmentB. 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.

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2. Human Capital InvestmentC. 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?

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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.

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3. DeregulationA. 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

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3. DeregulationB. 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)

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3. DeregulationSummary

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

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4. Easing Trade BarriersA. 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?

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4. Easing Trade BarriersB. 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

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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?

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