The Supply-Side Model
and the New Economy
Chapter 10
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By the early 1980s, Keynesian discretionary
demand-side stabilization policies were no
longer effective.
The output-inflation (Phillips curve) trade-off
no longer in evidence.
Birth of the Rational expectations School of
macroeconomics. A new paradigm!
Hallmarks of this school of thought:
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•
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Greater role of expectation
Uncertainty
Asymmetric information.
This was helped by more advanced and
sophisticated time-series analyses.
Causes of the so-called demise of
Keynesian macroeconomics:
Expectations-augmented AS curve
Crucial assumption: Information is
asymmetric. By assumption, employers
know the changes in cotemporaneous
prices and nominal wages but workers
do not know these changes in P and W
in the current period.
(Fig. 10.1)
1.
Assume the economy is at P0,Y0 in the (P,Y) space and
assume P0 =2.
2.
As a result of a demand-side stabilization policy, AD0
shifts right to AD1. This causes P to increase to P1 (from 2
to 5), and W0 increases to W1 (from 12 to 15).
3.
Since information is asymmetric, employers know that
prices have increased by more than 100% but workers
see only the rise in their nominal wages (from 12 to 15).
4.
The asymmetry of information leads to more demand for
labor (since the real wage is lower) but workers think they
are better off and supply more labor.
5.
As a result, employment increases to n1.
6.
As a result of n increasing, Y increases to Y1.
7.
We link the points (P1,Y1) and (P0,Y0) to obtain the
adaptive expectations AS curve (AE-AS).
An Expectations-Augmented Explanation
of the Paradigm Shift
Do workers misinterpret observed changes
in nominal wage as changes in real wage only
in the short and medium term?
(Fig. 10.2)
The last point covered in Fig 10.1 (point 7) is
our starting point in Fig. 10.2.
We note that the positively sloped AE-AS
curve facilitates the output-inflation tradeoffs.
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Eventually, workers catch on and realize that real
wages are going down. They then update their
expectations and when another round of
expansionary fiscal or monetary stabilization is
anticipated they indulge in pro-active long-term
contracts (require that W=30 so that real wage
remains 6). Information has become symmetric!
Employment equilibrium is back at n0 ; with Y = Y0
but P = P1.
We link the points (P1,Y0) and (P0,Y0) to obtain the
rational expectations AS curve (RE-AS). Note
that the RE-AS curve is vertical! This is the
theoretical center piece of the new supply-side
paradigm.
The RE-AS is also known as the new classical
AS curve.
How can an economy move from the
positively sloped AE-AS curve to the
vertical RE-AS curve?
Two requirements:
1. Sophisticated labor markets where market
power can influence long-term labor
contracts.
2. Fully articulated and efficient bond markets.
Shifting the AS curve
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According to this new paradigm, shifting
AD affects only the price level (P).
To increase GDP growth, the only viable
option is to shift the AS to the right
(supply-side model).
The main elements of supply-side
economics are:
1. Significant income/personal tax cuts.
2. Extensive corporate/business tax cuts.
3. Substantial deregulation
Shifting the AS curve
Significant income/personal tax cuts
Labor Supply = f(real wage, personal tax rates, macro outlook)
(+)
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(-)
(+)
Workers generally perceive tax cuts as temporary so they
work More hours. Others see the incentive of joining the
labor force. The labor supply curve shifts to the right. Tax
rate increases shift the labor supply curve to the left.
Another explanation (Fig. 10.4): An increase in the tax
rate (t) requires an increase in real wage (to keep
employment at n0) which results in an upward shift (left) in
the labor supply curve (Fig, 10.4a).
In the rational expectations paradigm, taxes also influence
the labor market (not just disposable income and
consumption).
Shifting the AS curve
Extensive corporate/business tax cuts
Labor Demand = f(real wage, business tax rates, macro outlook)
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(-)
(-)
(+)
Cuts in corporate/business taxes cause the labor
demand curve to shift to the right (Fig. 10.5).
Deregulation
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Increases innovation and productivity (Fig. 10.6).
Supply-Side Stabilization
Incorporating the three major supply-side policies
(Fig. 10.7).
1. We start from a low recessionary GDP growth rate
(Y0) with RE-AS. Assume there is asymmetric
information.
2. Combining personal and business tax cuts with
substantial deregulation causes the RE-AS curve to
shift to the right.
3. We have higher Y (higher production function),
higher n (both supply and demand of labor shift to
the right) and lower price level!
 A supply-side story: Ireland and IT.
Stagflation
Raising inflation and falling rates of employment
and GDP growth (Fig. 10.8).
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The 1970s oil shocks and stagflation in the
U.S., Western Europe and Japan.
Late 2008: Rising prices and slowing growth.
The New Economy
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Traces its roots to the supply-side policies implemented in
the early 1980s.
Deregulation fostered technological progress and led to an
upward shift in the production function.
Strong macroeconomic outlook caused labor demand and
supply curves to shift to the right. So the equilibrium
employment increased.
The RE-AS curve shifted to the right.
Hallmark of the New Economy: GDP growth without higher
inflation.
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Mid 1990s-2000: U.S. average quarterly GDP growth rate was 5%
and unemployment was in the 3% range, with no significant
increases in the rate of inflation.
The New Economy and the productivity puzzle.
The Identification Problem
(Fig. 10.9)
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Oxford Dictionary of Economics definition:
“The problem of estimating the parameters of structural
equations when all that can be observed is equilibrium
positions. For example, in the market for a particular good,
if demand conditions vary and supply conditions do not,
comparing prices and quantities at different times allows
us to determine the supply equation. If supply conditions
vary and demand conditions do not, we can estimate the
demand equation. But if both supply and demand
conditions vary, regressing quantity on price tells us
nothing. The identification problem can be resolved only if
either theory or the results of other studies inform us that
some explanatory variables affect one side of the market
but not the other.”
A Keynesian Explanation of the
New Economy
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Keynesians argue that all AS curves (no matter
their shape) will shift to the right if the production
curve shifts upward as a result of higher labor
productivity.
Fig. 10.10a shows that even a Keynesian AS
curve shifts to the right as a result of higher
productivity and will lead to the same results (New
Economy results, Fig. 10.10b).
The New Economy Compared to
the ‘Old Economy’
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The old or traditional economy: Keynesian AS.
The New economy: (vertical AS) supply side
See Table 10.1
Reconciling the Two Models
In the developed economies: In the
long-run reconciliation will be highly
unlikely.
Possibility of a quasi-paradigm. A
transition from the short-run AS curve
to a long-run supply-side model.
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This implies that in the short-run there is
room for demand-side stabilization
policies.
Robert Lucas and the ‘Islands’
economy
 The
outlook for the New Economy
 Which
model can consistently explain
all macroeconomic behavior in the
developed economy?
 Discussion:
Article 10.2