Macroeconomics ECO 110/1, AAU
Lecture 10
SUPPLY-SIDE POLICY
Eva Hromádková, 26.4 2010
Overview
2
 How
does aggregate supply affect outcomes of the
economy?
 The
 How
best of both worlds: low inflation & low unempl.
can we shift AS curve?
Aggregate Supply
Motivation for supply-side policies
3

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.
Aggregate Supply
Shape of the AS curve
4

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
Aggregate Supply
Keynesian AS
5

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
Aggregate Supply
Monetarist AS
6


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)

LO1
AS is vertical and located at
full employment.
Aggregate Supply
Hybrid AS
7



LO1
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.
Aggregate Supply
The Inflation-Unemployment Tradeoff
8

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
Aggregate Supply
The Inflation-Unemployment Tradeoff - Illustration
9
Aggregate
supply
C
B
A
AD3
AD2
AD1
REAL OUTPUT
LO2
A trade-off between
unemployment and inflation.
INFLATION RATE
PRICE LEVEL
Increases in aggregate
demand causes . . . . .
Phillips curve
c
b
a
UNEMPLOYMENT RATE
Aggregate Supply
The Phillips Curve
10

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
Aggregate Supply
The Phillips curve - UK
11
The Phillips curve in the UK, 1861 - 1913
LO2
Aggregate Supply
The Phillips curve - USA
12
The Phillips curve in the US, 1961 - 1969
LO2
Aggregate Supply
Shifts of the AS curve
13

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)
Aggregate Supply
Rightward shift of the AS curve
Price Level
(average price per unit of output)
14
Rightward AS shifts reduce AS1
unemployment and inflation
E1
AS2
E2
AD
0
Output (real GDP per period)
Aggregate Supply
Rightward shift of the AS curve – Shift of Phillips curve
15
Inflation Rate (percent)
PC1
Rightward AS shifts cause
leftward Phillips curve shifts
PC2
a
4
b
2
1
2
3
4
5
6
Unemployment Rate (percent)
7
8
Aggregate Supply
Policy tools
16


Rightward shifts of the aggregate supply curve
always generate desirable macro outcomes.
The AS curve can shift rightward through:
1.
2.
3.
4.
5.
LO3
Tax incentives for saving, investment and work.
Human capital investment.
Deregulation.
Trade liberalization.
Infrastructure development.
Two Theories for Getting the Economy Moving
17
Supply-Side Theory
Keynesian Theory
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
Firms invest more and try new
ventures; jobs are created;
people work harder aggregate
supply increases.
2
People use increased income to
buy more goods and services:
aggregate demand 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.
LO3
Supply-Side Policies
1. Tax Incentives
18


LO3
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
Supply-Side Policies
1. Tax Incentives
19

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
1. Tax Incentives
Tax systems in our countries
20
Corporate
Personal
Payroll
Austria
25%
21-50%
Belarus
24%
12%
China
25%
5-45%
Czech Rep
21%
15%
Georgia
15%
20%
Kazakhstan
17.5%
10%
11%
Russia
13-20%
13%
10-26%
Slovak Rep
19%
19%
USA
15-39% (fed)
0-12% (state)
0-35%(fed)
0-10.3%
Ukraine
25%
15%
Uzbekistan
12%
13-30%
35%
47.5%
Macedonia
Nigeria
LO3
15.3%, 2.9%
(regressive)
1. Tax Incentives
Effects
21
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 selfemployment.
Investment:
 Aggregate supply will be constrained if high tax rates
discourage investment.
LO3
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?
1. Tax Incentives
Tax-Induced Supply Shifts
23



LO3
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.
1. Tax Incentives
Quantification of effect: The Tax Elasticity of Supply
24

The tax elasticity of supply is the percentage change
in quantity supplied divided by the percentage
change in tax rates.
Tax elasticity % change in quantity supplied
=
of supply
% change in tax rate


LO3
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
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?
1. Tax Incentives
Savings and Investments Incentives
26

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
2. Human Capital Investment
27

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
 Thus,
cannot hire more workers – they raise prices
policies focused on decreasing structural
unemployment shift AS curve to the right
LO3
2. Human Capital Investment
A. Worker Training
28

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
 In
LO3
as output per hour (or day, etc.).
the short run they impose additional labor costs
2. Human Capital Investment
B. Education Spending
29
Expansion and improvement of the efficiency of the
educational system => higher HC
Examples:
 School vouchers




LO3
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.
2. Human Capital Investment
C. Reducing discriminatory barriers
30
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)


LO3
Q: Yes/no? What is your opinion?
2. Human Capital Investment
D. Transfer Payments
31

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
3. Deregulation
A. Factor markets
32


The added costs of production due to regulation shift the
aggregate supply curve to the left.
Minimum wage:



Mandatory benefits


Health benefits, leaves of absence
Occupational health and safety

LO3
Main goal: ensure a decent standard of living (CR 8000 CZK)
By-product: limits ability of employers to hire additional people
minimum safety conditions at workplaces
3. Deregulation
B. Product markets
33

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
3. Deregulation
Summary
34



LO3
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
4. Easing Trade Barriers
A. Factor and product markets
35



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
LO3

Q1: What is the difference between tariff and quota?

Q2: Why do countries introduce these protectionist measures?
4. Easing Trade Barriers
B. Immigration
36
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
5.Infrastructure Development
37

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