Supply-Side Policy:
Short-Run Options
Chapter 16
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Supply-Side Policy
• Any policies that alter the willingness or
ability to supply goods at various price levels
will shift the aggregate supply curve
– How does the aggregate supply curve affect macro
outcomes?
– How can the aggregate supply curve be shifted?
16-2
Aggregate Supply
• The macro economy experienced stagflation in
the 1970s
• Stagflation: The simultaneous occurrence of
substantial unemployment and inflation
• No shift of the aggregate demand curve can
solve inflation and unemployment at the same
time
16-3
Aggregate Supply
• The shape and shifts in aggregate supply hold
the clues on how stagflation may occur
• Aggregate supply: The total quantity of
output that producers are willing and able to
supply at alternative price levels in a given
time period, ceteris paribus
16-4
Shape of the AS Curve
• The response of producers to an AD shift is
expressed in the slope and position of the AS
curve
• There are three views concerning the shape
– Keynesian AS
– Monetarist AS
– Hybrid AS
16-5
Keynesian AS
• Little risk of inflation during
a recession
• Producers increase output,
not prices, when aggregate
demand picks up
• Inflation becomes a problem
only if demand increases
beyond capacity
16-6
Monetarist AS
• Changes in money supply
affect prices but not output
• Rising prices don’t entice
producers to increase output
because costs rise just as
fast
• AS is vertical and located at
full employment
16-7
Hybrid AS
• At low rates of output AS is
horizontal
• At high rates of output AS is
nearly vertical
• In between, AS is gently
upward sloping
• The closer the economy is to
capacity, the greater the risk
that fiscal or monetary
stimulus will cause inflation
16-8
The Inflation-Unemployment Tradeoff
• Fiscal and monetary policies cannot reduce
unemployment and inflation at the same time
• Because AS curve is upward-sloping
– Rightward shifts of AD increase both prices and
output
– Leftward shifts of AD decrease prices and output
16-9
The Phillips Curve
• Phillips curve: A historical (inverse)
relationship between the rate of unemployment
and the rate of inflation; commonly expresses
a trade-off between the two
• The trade-off originates in the upward-sloping
AS curve
16-10
Inflation Rate (percent)
The Phillips Curve
11
10
9
8
7
6
5
4
B
3
2
A
1
0
C
1
2
3
4
5
6
7
Unemployment Rate (percent)
16-11
The Phillips Curve Trade-Off
A trade-off between
unemployment and inflation
Aggregate
supply
C
B
A
AD3
AD2
AD1
REAL OUTPUT
INFLATION RATE
PRICE LEVEL
Increases in aggregate
demand cause . . .
Phillips curve
c
b
a
UNEMPLOYMENT RATE
16-12
The Inflationary Flashpoint
• Phillips curve indicates there is bound to be a
trade-off between unemployment and inflation
at some point in economic expansions and
contractions
• Inflationary flashpoint: The rate of output at
which inflationary pressures intensify; point of
inflection on AS curve
16-13
Shifts of the AS Curve
• Many economists argue that the economy can
attain lower levels of unemployment without
higher inflation
• Only a rightward shift of the AS curve can
reduce unemployment and inflation at the
same time
16-14
Shifts of Aggregate Supply
Price Level
Rightward AS shifts reduce AS1
unemployment and inflation
E1
AS2
E2
AD
0
Output
16-15
Phillips Curve Shift
• The Phillips curve shifts left when the AS
curve shifts right, and vice versa
• The unemployment-inflation trade-off eases
when the Phillips curve shifts to the left
16-16
Phillips Curve Shift
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
16-17
Leftward AS Shifts: All Bad News
• Leftward AS shifts create stagflation
• Supply-side shocks can shift the AS curve to
the left
• Leftward shifts of aggregate supply cause
rightward shifts in the Philips curve
16-18
Policy Tools
• Policy options to shift AS rightward include:
–
–
–
–
–
Tax incentives for saving, investment, and work
Human capital investment
Deregulation
Trade liberalization
Infrastructure development
16-19
Two Theories for Getting the
Economy Moving
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.
16-20
Tax Incentives
• In Keynesian economics, tax cuts are used to
increase aggregate demand
• Direct effects of taxes on the supply of goods
are the concern of supply-side economists
• Taxes not only alter disposable income but
also affect incentives to work and produce
16-21
Marginal Tax Rates
• Supply-side theory places special emphasis on
marginal tax rates
– Marginal Tax Rate: The tax rate imposed on the
last (marginal) dollar of income
• If the marginal tax rate is high, there is less
incentive to work
16-22
Marginal Tax Rates
• Progressive marginal tax rates discourage
entrepreneurship
• Growth rate, investment, and employment of
small businesses are affected by marginal tax
rates
• Corporate investment decisions are also
affected by corporate tax rates
16-23
Changes in Marginal Tax Rates
Since 1915
16-24
Tax-Induced Supply Shifts
• A reduction in marginal tax rates shifts the
aggregate supply curve to the right
• Work effort, entrepreneurship, and investment
increase
• Tax rebates do not shift AS, because they are a
one-time windfall and do not effect marginal
tax rates
• Tax rebate: A lump-sum refund of taxes paid
16-25
The Tax Elasticity of Supply
• If the tax elasticity of supply were large
enough, a tax cut might actually increase tax
revenues
Tax elasticity % change in quantity supplied

of supply
% change in tax rate
16-26
Savings and Investment Incentives
• Supply-side economists favor tax incentives
that encourage saving
• Tax incentives for investment are an
alternative lever for shifting aggregate supply
– Examples include investment tax credits and
cutting capital gains tax rates
16-27
Human Capital Investment
• Tax incentives to businesses that offer worker
training are a viable policy tool for future
shifts in aggregate supply
• Expansion and improvement of the education
system through increases in education
spending will develop human capital gradually
16-28
Human Capital Investment
• Addressing discriminatory barriers through
affirmative action programs can reduce
artificial barriers between job seekers and job
openings
• Restructuring of transfer payments can reduce
impact on labor supply
16-29
Deregulation
• Government regulations limit the flexibility of
producers and tend to raise production costs,
shifting AS to the left
• Government intervention in factor markets
increases the cost of supplying goods and
services in many ways
16-30
Minimum Wage and Mandatory Benefits
• Minimum-wage laws increase the cost to
employers of hiring additional workers,
shifting the aggregate supply curve leftward
• By requiring employers to provide specific
fringe benefits, the government increases the
cost of doing business
16-31
Occupational Health and Safety
• OSHA, the Occupational Health and Safety
Administration, forces employers to conform
to certain minimum safety conditions at
workplaces
• The additional costs shift the aggregate supply
curve to the left
16-32
Product Markets
• Government regulations also raise costs in
product markets
• Regulation of transportation costs constrains
producer’s ability to respond demand increases
• Food and drug standards, enforced by the
Food and Drug Administration (FDA), cause
companies to incur additional costs as well
16-33
Reducing Costs
• 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
16-34
Easing Trade Barriers
• In the factor markets, reducing tariffs or quotas
on imports of production inputs decrease
production costs and increase aggregate supply
• In the product markets, foreign suppliers
increase the quantity of output available at any
given price level, helping flatten the AS curve
16-35
Easing Trade Barriers
• Free trade pacts like the North American Free
Trade Agreement (NAFTA) tend to shift
aggregate supply rightward
• Allowing immigration of foreign-born workers
can increase the pool of skilled labor and help
shift the aggregate supply curve to the right
16-36
Infrastructure Development
• Improving the nation’s infrastructure reduces
costs of supplying goods and services
• Infrastructure: The transportation,
communications, education, judicial, and other
institutional systems that facilitate market
exchanges
16-37
Expectations
• Because investment is always a bet on future
economic conditions, expectations directly
affect the shape of the AS curve
16-38
Rebuilding America
• The output of the American economy depends
on public as well as private investment
• Declining infrastructure investment reduces
actual and potential output
• Infrastructure improvements will increase
aggregate supply, boosting both short-run and
long-run economic outcomes
16-39
Supply-Side Policy:
Short-Run Options
End of Chapter 16
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.