Supply-Side Policy

2. Supply-Side Policy • Fiscal and monetary policies focus on the demand side of the macro economy. These policies shift the aggregate demand curve. • Policies that alter the willingness or ability to supply goods at various price levels will shift the aggregate supply curve. They are supply-side policies.

3. Learning Objectives • 16-01. Explain why the short-run AS curve shifts upward. • 16-02. Discuss how an unemployment-inflation trade-off arises. • 16-03. Identify the tools of supply-side policy.

4. Aggregate Supply • In the 1970s, stagflation occurred. • Stagflation: the simultaneous occurrence of substantial unemployment and inflation. • Shifting AD to “fix” stagflation is not possible. • Increase AD: unemployment falls and inflation rises. • Decrease AD: unemployment rises and inflation falls. • Supply-side policy arose to provide an answer to stagflation.

5. Shape of the AS Curve • Each policy school in economics has an opinion about what the AS curve looks like. • Keynesians: • AS is horizontal. • An AD shift to the right in recession increases Q but does not increase P. • Inflation becomes a problem only after AD shifts past Q*, the production capacity.

6. Shape of the AS Curve • Each policy school in economics has an opinion about what the AS curve looks like. • Monetarists: • Changes in the money supply affect prices but not output. • An AD shift to the right increases inflation. • AS is a long-run concept and is vertical.

7. Shape of the AS Curve • Each policy school in economics has an opinion about what the AS curve looks like. • Hybrid version: • Most economists now see an AS curve with an upward slope that increases near full employment. • Inflation accelerates in that region of the curve as AD shifts right.

8. Impact of the Hybrid AS Curve • Shifts of AD affect both prices and output. • Outcomes of fiscal and monetary policy depend on how close the economy is to full employment. • The closer we are, the greater the risk that fiscal or monetary stimulus will spill over into inflation.

9. Inflation-Unemployment Trade-Off • The message of the upward-sloping AS curve is that demand-side policies alone can never succeed completely; they will always cause some unwanted inflation or unemployment. • There is an inflation-unemployment trade-off, which is expressed in the Phillips curve.

10. The Phillips Curve Trade-Off • As the economy moves from point A to B to C(left picture), the inflation-unemployment trade-off shifts from point a to b to c (right picture) on the Phillips curve.

11. The Inflationary Flashpoint • The upward-sloped AS curve has a point at which inflation rockets upward as the decrease in unemployment slows. • It is called the inflationary flashpoint: the output at which inflationary pressures intensify; the point on the AS curve where slope increases sharply.

12. Shifts of the AS Curve • Rightward shift of AS: • Good news! Reduces unemployment and inflation at the same time. • Also increases output. • Shifting AD cannot do this. • Leftward shift of AS: • Bad news! Both unemployment and inflation increase, and output decreases.

13. The Misery Index • Misery index: a simple sum of the inflation and unemployment rates. • If AS shifts right, both elements decrease and the misery index falls sharply. • If AS shifts left, both elements increase and the misery index rises sharply.

14. What Shifts the AS Curve? • Shifting AS right: • Policies that provide incentives for suppliers to increase production. • Tax incentives for saving, investment, and work. • Human capital investment. • Deregulation. • Trade liberalization. • Infrastructure development.

15. What Shifts the AS Curve? • Shifting AS left: • Policies that provide disincentives for suppliers to increase production. • Tax increases for saving, investment, and work. • Deteriorating human capital investment. • Excessive, costly regulation. • Trade restrictions. • Decaying infrastructure. • Negative external shocks, such as natural disasters and war.

16. Tax Incentives • Keynesians cut taxes to increase AD. • Supply-siders note that high tax rates destroy the incentive to work and produce, which ends up reducing output. • Low tax rates encourage people to earn more because more ends up in disposable income and less goes to the government.

17. Tax Incentives • Supply-siders emphasize a reduction in marginal tax rates for both workers and firms. • Marginal tax rate: the tax rate imposed on the latest earned (marginal) dollar of income. • High marginal tax rates provide a disincentive to • Earn more. • Start or expand a business. • Increase investment spending.

18. Tax Incentives • A reduction in marginal tax rates will shift AS to the right. • On the other hand, a tax rebate (one-time tax refund) adds to disposable income but does not affect the marginal tax rate, so AS does not shift.

19. Savings Incentives • Keynesians treat saving as a leakage to the circular flow, because they emphasize spending. • Supply-siders emphasize the importance of saving for financing more investment and economic growth. • They favor tax incentives that encourage saving and greater tax incentives for investment.

20. Investment Incentives • Supply-siders advocate tax incentives for investment: • Reduced taxes on capital gains and dividends. • Larger capital expensing of new investment. • The goal is to expand investment spending, which increases the capacity to produce. This will shift AS to the right.

21. Human Capital Investment • Human capital: the knowledge and skills possessed by the workforce. • Supply-siders encourage investments in human capital to provide the knowledge and skills needed to reduce structural unemployment. • This can be done by providing tax credits to employers who offer more worker training.

22. Other Human Capital Incentives • Supply-siders want to increase human capital by expanding and improving the educational system. • Affirmative action programs are designed to reduce discriminatory barriers, which will shift AS to the right. • Transfer payments can become excessive and provide a disincentive for recipients to take a job. Welfare reforms in 1996 had a positive supply-side impact and kept basic welfare programs intact.

23. Deregulation • When government sets rules that directly affect employment and production decisions, it affects the AS curve. • Excessive regulation is costly to producers and will shift AS to the left. • Decreased regulation (or deregulation) reduces costs for producers and will shift AS to the right.

24. Deregulation • Government interventions that have good reasons for existing but shift AS to the left by increasing costs to producers. • Minimum wage. • Mandatory benefits. • Occupational health and safety. • Transportation costs. • Food and drug standards. • Environmental protection. • Supply-siders contend that regulatory costs are now too high.

25. Easing Trade Barriers • When production costs rise, AS shifts left. • Tariffs (taxes on imported goods) make input costs higher. • Immigration restrictions make it more difficult to overcome skill shortages. • By advocating the reduction of tariffs on inputs and improvement in the flow of immigrant workers, supply-siders note that production costs fall and AS shifts right.

26. Infrastructure Development • Infrastructure: the transportation, communications, education, judicial, and other institutional systems that facilitate market exchanges. • Improving these institutional structures makes commerce flow easier and therefore reduces costs. • Reducing costs will cause the AS curve to shift right.

27. Adverse Supply-Side Policies • The following policies shift AS to the left: • Higher marginal tax rates for individuals and businesses. • Increased taxes on saving and investment. • Letting infrastructure deteriorate. • Increased government regulation. • Increased trade barriers. • When AS shifts left, output decreases, unemployment rises, and inflation increases.