9
Demand-Side Equilibrium:
Unemployment or
Inflation?
Contents
● Meaning of Equilibrium GDP
● Mechanics of Income Determination
● Aggregate Demand Curve
● Demand-Side Equilibrium and Full Employment
● Coordination of Saving and Investment
● Changes on the Demand Side: Multiplier
Analysis
Real World Puzzle: Why does the
Market Permit Unemployment?
● Market economies coordinate the decisions of millions
of buyers and sellers to ensure the correct amount of C
goods are produced with most efficient prod means.
● Yet market economies stumble with periodic episodes of
mass UE and recessions.
● Widespread UE is a failure to coordinate economic
activity.
♦ If UE were hired, they could buy the goods firms can’t sell; and
revenues from these sales would allow firms to hire the UE.
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The Meaning of Equilibrium
GDP
● Recall: total production (GDP) = total income
● But total production need not = total spending
● If total expenditures > value of output produced
♦ (1) ↓inventory stocks → signals retailers ↑orders → signals
manufacturers ↑ production
♦ (2) if high levels of spending continue to deplete inventories →
firms ↑prices
● If total expenditures < value of output produced
♦ (1) ↑inventory stocks → signals retailers ↓orders → signals
manufacturers ↓ production
♦ (2) if low levels of spending continue → firms ↓prices
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The Meaning of Equilibrium
GDP
● Equilibrium on the Demand-side of the Economy
♦ GDP↑ when total expenditures > GDP
♦ GDP↓ when total expenditures < GDP
● Equilibrium can only occur when there is just enough
spending to absorb current level of prod. Then producers
conclude their Q and P decisions were correct.
● Equilibrium: total spending = total production
♦ Firms inventories remain at desired levels → no reason to ∆Q
or ∆P
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The Mechanics of Income
Determination
● Expenditure Schedule = table showing the relationship
between GDP and total spending
● Table 1:
♦ C is the Consumption f(x)
♦ I, G, and X-IM are all fixed regardless of the level of GDP
♦ C + I + G + X-IM = total expenditure
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TABLE 1. The Total Expenditure
Schedule
GDP (Y)
C
I
G
X - IM
Total Exp
4,800
3,000
900
1,300
-100
5,100
5,200
3,300
900
1,300
-100
5,400
5,600
3,600
900
1,300
-100
5,700
6,000
3,900
900
1,300
-100
6,000
6,400
4,200
900
1,300
-100
6,300
6,800
4,500
900
1,300
-100
6,600
7,200
4,800
900
1,300
-100
6,900
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FIGURE 1. Construction of the
Expenditure Schedule
C +I+ G
C + I + G + (X –IM)
X –IM = –$100
6,100
6,000
Real Expenditure
C+I
C is the C f(x). It is shifted up
by the amount of I ($900)
and G ($1,300) and shifted
down by the amount of X-IM
(-$100).
G = $1,300
C
4,800
I = $900
3,900
5,200
5,600
6,000
6,400
Real GDP
6,800
7,200
Slope of the expenditure
schedule = MPC because I,
G, and X-IM are assumed to
be constant and do not vary
with GDP.
The Mechanics of Income
Determination
● Use Table 2 to understand why $6,000B must be
equilibrium level of output.
● Any output below $6,000B → total expenditures > GDP
→ ↓inventories → ↑production
● Any output above $6,000B → total expenditures < GDP
→ ↑inventories → ↓production
● Equilibrium only occurs when Y = C + I + G + X-IM or
GDP = total expenditure, which happens at $6,000B.
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TABLE 2. The Determination of
Equilibrium Output
The Mechanics of Income
Determination
● Use Figure 2 to show why $6,000B must be the
equilibrium level of output.
● 45 degree line shows all points where output and
spending are equal.
♦ These are all points where the economy can possibly be in
equilibrium.
♦ Economy is not always on the 45 degree line but it is always on
the expenditure schedule.
♦ Equilibrium is shown where 45 degree line intersects the total
expenditure schedule.
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FIGURE 2. Income-Expenditure
Diagram
Output exceeds spending
7,200
45°
6,800
C +I +G +
(X – IM)
Real Expenditure
6,400
E
6,000
Equilibrium
5,600
5,200
4,800
0
Spending exceeds
output
4,800 5,200 5,600
6,000 6,400 6,800 7,200
Real GDP
Left of point E: total
expenditure schedule is
above the 45 degree line →
spending > GDP →
↓inventories and firms
↑prod.
Right of point E: total
expenditure schedule is
below the 45 degree line →
spending < GDP →
↑inventories and firms
↓prod.
The Aggregate Demand Curve
● The expenditure schedule is drawn for a fixed P level.
● Derive AD curve using the expenditure schedule.
● Recall  P level  shifts C f(x) downward
♦  P level (at fixed levels of DI)   purchasing power of
wealth by lowering the value of money-fixed assets
♦  P level  shifts the expenditure schedule downward
♦ ↓ P level  shifts the expenditure schedule upward
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The Aggregate Demand Curve
● How do changes in the P level impact real GDP on the
demand-side of the economy?
♦ ↑P level → ↓expenditures → ↓Equil level of GDP
♦ ↓P level → ↑expenditures → ↑Equil level of GDP
● We can now draw an AD curve (in Fig 3) where Y0, Y1,
and Y2 correspond to the GDP levels depicted in the 45
degree line diagram.
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FIGURE 3. The Effect of the Price
Level on Equilibrium AD
45
C0 + I + G + (X–IM)
E0
Price Level
Real Expenditure
C2 + I + G + (X–IM)
E2
E1
P1
E0
P0
C1 + I + G + (X–IM)
E1
E2
P2
AD
45
Y1
Y0
Y2
Real GDP
Change in P level
Y1
Y0
Real GDP
Y2
Movement along AD curve
The Aggregate Demand Curve
● AD has a (-) slope
♦ ↑P level → ↓C via ↓wealth
♦ ↑P level → ↓X-IM
■ Note: this also shifts the expenditure schedule down and lowers GDP.
● Each expenditure schedule describes only one P level. At
different P levels, the expenditure schedule is different so
equilibrium GDP is different.
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Demand-Side Equilibrium and
Full Employment
● Will economy achieve full employment without
inflation?
● If the economy always gravitates toward full
employment, then gov should leave the economy alone.
● We’ve shown that equil GDP is where 45 degree line
intersects the exp schedule, but we haven’t determined if
that equil level of GDP is at full employment.
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Demand-Side Equilibrium and
Full Employment
● If equil GDP > full employment level of GDP →
economy has inflation.
● If equil GDP < full employment level of GDP →
economy has unemployment.
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FIGURE 4. A Recessionary Gap
Potential
GDP
45°
C + I + G + (X – IM)
Here exp is too low to have full
emp. Happens if C, I, G, or X
are weak or P level is “too
high.”
B
UE occurs because there isn’t
enough output demanded to
keep entire L force working.
Real Expenditure
F
E
Recessionary gap
45°
6,000
7,000
Real GDP
Full emp = $7,000B and equil
GDP = $6,000B.
Full emp can be reached if exp
schedule shifts up to pt F. This
could happen without gov
intervention if ↓P level.
FIGURE 5. An Inflationary Gap
Potential
GDP
45°
Inflationary gap
B
E
Real Expenditure
C + I + G + (X – IM)
45°
Real GDP
Happens if C, I, G, or X are
very high or P level is “too
low.”
Full emp can be reached if
exp schedule shifts down to
pt F. This could happen
without gov intervention if ↑P
level.
F
7,000
Full emp = $7,000B and
equil GDP = $8,000B.
8,000
The Coordination of Saving
and Investment
● Must full employ level of GDP be an equilibrium? No!
● Ignore G and X-IM then we can restate equil GDP:
♦ Y=C+I
♦ Y–C=I
♦ S=I
● Reach full employment equil only if S = I.
♦ If S > I → spending is inadequate to support prod at full emp
→ GDP falls below potential and there is a recessionary gap.
♦ If I > S → spending exceeds potential GDP → production is
above full emp level and there is an inflationary gap.
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The Coordination of Saving
and Investment
● S is decided by households and I is decided by corporate
executives and home buyers.
● Their decisions are not well coordinated.
● Not clear the gov can solve the coordination problem of
UE.
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Changes on the Demand Side:
Multiplier Analysis
● Multiplier = (∆ in equil GDP)  (∆ in spending that
caused the ∆ in GDP)
● In Table 3, I rises by $200B (from $900B in Table 1), yet
equil GDP rises by $800B (not just $200B). Why?
♦ Multiplier > 1 because one person’s spending is another
person’s income. Note: multiplier = 4 here.
♦  spending   income
♦ A portion of the ↑ in income is spent on C, creating more
income, which in turn creates more C, etc.
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TABLE 3. Total Expenditure after a
$200 Billion Increase in Investment
FIGURE 6. Illustration of the
Multiplier
45
C + I1 + G + (X – IM)
E1
C + I0 + G + (X – IM)
Multiplier =
∆Y/∆I =
$800/$200 = 4
Real Expenditure
Or multiplier =
1/(1-MPC) =
1/(1-0.75) = 4
$200 billion
E0
0
6,000
6,800
Real GDP (or Y)
Changes on the Demand Side:
Multiplier Analysis
● Multiplier = 1  (1 - MPC)
♦ MPC in U.S. has been estimated to be about 0.95, implying that
the multiplier is 20.
♦ In fact, the multiplier in U.S. is < 2.
● Factors that reduce the size of the multiplier
♦ International trade
♦ Inflation
♦ Income taxation
♦ Financial system
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The Multiplier Is a General
Concept
● ∆I has same multiplier effect as a ∆C, ∆G, or ∆(X - IM).
● Consequently, trade links the GDPs of major economies.
♦  GDP in a foreign country   its IM, a portion of which
are X from U.S.
♦ Growth in U.S. X has a multiplier effect, ↑GDP in U.S.
♦ Booms and recessions tend to be transmitted across national
borders.
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The Multiplier and the
Aggregate Demand Curve
●  spending  shifts AD by an amount given by the
oversimplified multiplier formula (1/(1-MPC)).
● In Fig 7, I has risen by $200B which shifts AD out by
$800B (i.e., 4 (the multiplier) x $200B).
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FIGURE 7. Two Views of the
Multiplier
45
C + I1 + G + (X – I M )
C + I0 + G + (X – I M )
Real Expenditure
E1
$200 billion
E0
6,000
0
Price Level
D0
6,800
D1
E0
E1
100
D 1 (I = $1,100)
D 0 (I = $900)
6,000
6,800
Real GDP
Supply-Side Equilibrium:
Unemployment and
Inflation?
Contents
● Aggregate Supply Curve
● Equilibrium of AD and AS
● Inflation and the Multiplier
● Recessionary and Inflationary Gaps Revisited
● Adjusting to a Recessionary Gap or an
Inflationary Gap
● Stagflation from an Adverse Supply Shock
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The Aggregate Supply Curve
● Like AD, AS is a curve and not a fixed number.
● Qs by firms depends on prices, wages, other input costs,
and technology.
● AS represents the relationship between P level and GDP
supplied, holding all other determinants of Qs fixed.
● AS has a (+) slope → ↑P → ↑Qs
● Firms are motivated by profit.
♦ Profit per unit = P – AC
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FIGURE 1. An Aggregate Supply
Curve
Price Level
S
S
Real GDP
Why does the Aggregate Supply
Curve have a Positive Slope?
● Many input prices are fixed for certain periods of time.
♦ Long-term contracts for L or raw materials
● Firms choose Qs by comparing selling prices with
production costs which depend on input prices.
♦ If ↑selling prices while input costs are fixed → ↑Qs
♦ If ↓selling prices while input costs are fixed → ↓Qs
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Shifts of the Aggregate Supply
Curve
● Costs of production are constant along the AS curve.
●  costs of production  shifts AS curve
1. Money wage rate
● wages account for more than 70% of all prod costs.
♦ ↑wages → ↓profit at any given P of output → ↓Qs
♦ ↑wages → shifts AS inward and ↓wages → shifts AS outward
2. Prices of other inputs
♦ ↑P of any input → shifts AS inward and ↓P of any input →
shifts AS outward
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Shifts of the Aggregate Supply
Curve
3. Technology and productivity
● Technological breakthrough that ↑L productivity → ↑output
per hour of L → ↑profit per unit → ↑Qs
● Technological improvements shift AS outward
4. Available supplies of labor and capital
● AS curve shifts out if L force↑; ↑L quality; or ↑K stock
because more output can be produced at any given P level.
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FIGURE 2. A Shift of the Aggregate
Supply Curve
S1 (higher wages)
S0 (lower wages)
B
Price Level
100
A
S1
S0
5,500 6,000
Real GDP
Equilibrium of Aggregate
Demand and Supply
● Intersection of AD and AS determine the equilibrium
level of real GDP and the P level.
● Equilibrium (in Fig 3) occurs at a P level = 100 and GDP
= $6,000B.
♦ At higher P levels, like 120, Qs > Qd by $800B → ↑inventories
→ ↓prices and ↓output.
♦ At lower P levels, like 80, Qd > Qs by $800B → ↓inventories
→ ↑prices and ↑output.
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FIGURE 3. Equilibrium Real GDP and
the Price Level
S
Price Level
D
130
120
110
100
90
80
E
S
D
5,200 5,600 6,000 6,400 6,800
Real GDP
Inflation and the Multiplier
● Recall: multiplier effect suggests A’s spending becomes
B’s income, and B’s spending becomes C’s income, etc.
● Earlier discussion focused on spending and assumed the
P level was fixed.
♦ Focused on the D-side equilibrium and ignored the reactions of
firms (i.e., the S-side).
● Will firms supply the additional demand without ↑P?
♦ Not if AS slopes upward!
● Inflation   size of the multiplier
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Inflation and the Multiplier
● In Fig 4, ↑I by $200B which shifts AD out by $800B
($200B x oversimplified multiplier of 4).
♦ Shown by the movement from E0 to A.
● Firms react to higher levels of spending (shift of AD at P
level = 100) by ↑output and ↑prices.
♦ Shown by the movement from E0 to E1 –along AS curve.
● ↑P level → ↓purchasing power of money-fixed assets →
↓C and ↓X-IM
♦ Shown by the movement from A to E1 –along new AD curve.
● Multiplier is only 2 now = ∆Y/∆I = $400B/ $200B.
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FIGURE 4. Inflation and the Multiplier
Assume I rises by $200B. This
raises total expenditure (or Q of
AD) by $800 (= $200B x multiplier
of 4).
D1
Price Level (Y)
$800
billion
130
120
110
100
90
80
If AS were horizontal → multiplier
= 4 and equil GDP would rise to
$6,800B.
S
D0
E1
E0
D1
D0
S
6,000 6,400 6,800
Real GDP (Y)
NOTE: Amounts are in billions of dollars per year.
If AS were vertical → multiplier =
0 and equil GDP would remain at
$6,000B.
Here AS is upward sloping and
↑P level with the shift in AD. The
multiplier is 2 (= $400B/$200B).
Recessionary and Inflationary
Gaps Revisited
● Short run: equilibrium of AS and AD may or may not
equal full employment GDP
♦ Recessionary gap: equilibrium GDP < full employment or
potential GDP
♦ Inflationary gap: equilibrium GDP > full employment or
potential GDP
● Long run: wages adjust to labor market conditions to
make equilibrium GDP = full employment or potential
GDP
♦ But this may take a long time!
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Adjusting to a Recessionary
Gap
● In Fig. 5, equil GDP falls below the full employment
level.
● This might be caused by weak C or low I.
● Loose L market
♦ There is UE and jobs are hard to find.
♦ Employees may be anxious to keep their jobs.
♦ Workers won’t win ↑wage and wages might fall.
● If ↓wages → AS shifts outward →↓P level and ↓UE
● Deflation erodes the recessionary gap –but this process
happens very slowly!
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FIGURE 5. The Elimination of a
Recessionary Gap
Recessionary gap =
$1,000B.
Potential
GDP
S0
Price Level
S1
Weak spending and UE at
pt E.
Weak labor markets put
pressure on wages to fall.
D
E
100
B
F
S0
Recessionary
gap
D
S1
6,000
7,000
Real GDP
Falling wages shift AS
outward which lowers
prices.
Falling prices stimulate C
and net X.
Adjusting to a Recessionary
Gap
● In the real economy, however, wage reductions are slow
and uncertain, particularly in the post-WWII period.
● E.g., even with the severe recession of 1981-82 where
UE reached 10%, prices and wages were not forced
down –though their rates of increase were.
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Adjusting to a Recessionary
Gap
● Why haven’t wages fallen much since WWII?
● Institutional factors: like min wages, union contracts, and
gov regulations that place legal floors on wages and
prices. These were all developed since WWII.
● Psychological resistance: firms are reluctant to cut wages
for fear their employees will resent it and reduce effort.
♦ But why wasn’t this true prior to WWII?
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Adjusting to a Recessionary
Gap
● Business cycles were less severe: after WWII so firms
and workers wait out the bad times rather than accept
wage or price cuts.
● Firms lose their best workers: if a firm cuts wages, it
may lose its best employees. Individual productivity is
hard to measure. The best workers have the greatest
opportunities elsewhere.
♦ Should have been true before WWII.
● With sticky wages and prices, cyclical unemployment
may last a long time.
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Adjusting to a Recessionary
Gap
● Does the Economy Have a Self-Correcting Mechanism?
♦ The economy will self-adjust eventually.
■ wages   demand for labor
■ prices   demand for goods and services
♦ But many people believe that gov intervention should
help to speed up the process.
● Eg., Recovery from 1990-91 recession took almost 4
years.
♦ UE fell from 7.7% to 5.4%
♦ Inflation fell from 6.1% to 2.7%
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Adjusting to a Recessionary
Gap
● An Example from Recent History: Disinflation in Japan
in the 1990s.
♦ Recovery from the 1990-91 recession was weak and
long delayed, but it did eventually come.
♦ Practical question: How long can we afford to wait?
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Adjusting to an Inflationary
Gap
● When spending is strong, equil GDP > full employment
GDP.
● Labor markets are tight.
♦ Jobs are plentiful and L is in demand.
♦ Firms will have trouble filling vacant positions and may offer
higher wages to lure workers away from their current jobs.
● ↑wages → shifts AS inward →↓output and ↑prices
● Inflation occurs because buyers are demanding more
than the economy is capable of producing at normal
operating rates.
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Adjusting to an Inflationary
Gap
● In Fig. 6, AS shifts inward → ↑P level → ↓purchasing
power of consumer wealth →↓C and ↓X-IM.
♦ Shown by the movement from E to F along AD curve.
● Stagflation occurs in the movement from E to F as ↓GDP
and ↑P level.
● This process takes time because wages and prices adjust
slowly!
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FIGURE 6. The Elimination of an
Inflationary Gap
Potential
GDP
S1
D
Price Level
S0
F
E
B
S1
Inflationary
gap
S0
Real GDP
D
Adjusting to an Inflationary
Gap
● Demand Inflation and Stagflation
● Inflationary gap is caused by high levels of spending.
♦ High demand for goods pushes prices and wages higher.
♦ Often hear business managers and journalists claim that
↑wages are causing inflation.
♦ Yet, ↑wages are a symptom not the cause of inflation.
● Stagflation that follows a period of excessive AD is
comparatively benign; output is falling, but it is still
above potential GDP.
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Adjusting to an Inflationary
Gap
● U.S. economy experienced an episode of stagflation
between 1988 and 1990.
♦ Economy reached UE rate of 5% (15 year low).
♦ Inflation rose from 4.4% to 6.1% to cure the inflationary gap.
♦ GDP growth rate fell from 3.5% in 1988 to -0.2% in 1990.
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Stagflation from an Adverse
Supply Shock
● In 1973, OPEC x 4 the P of oil.
♦ ↑costs of production for U.S. firms
● In 1979-80, OPEC struck again but P of oil x 2.
● Same thing happened during 1990 Gulf War –but to a
smaller extent.
● ↑P oil → inward shift of AS → ↓GDP and ↑P level.
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FIGURE 7. Stagflation from an
Adverse Shift in AS
In 1973, ↑P of oil x 4
→ ↓real GDP by 1%
and ↑P level by 19%.
Data from 1973
D
S1
Price Level
S0
A
42.2
35.4
E
S1
D
S0
3,870
3,900
Real GDP
Managing Aggregate
Demand:
Fiscal Policy
Contents
● Great Fiscal Stimulus Debate
● Income Taxes & the Consumption Schedule
● The Multiplier Revisited
● Planning Fiscal Policy
● Choice Between Spending Policy & Tax Policy
● Some Harsh Realities
● Supply-Side Tax Cuts
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Great Fiscal Stimulus Debate of
2009-10
● Has the $787B stimulus worked?
● Republicans: No
♦ Too much spending
♦ Not enough tax cuts
♦ ↑budget deficit
● Democrats: Yes
♦ ↑AD and moderated the recession
♦ ↑G impacts the economy sooner and with more certainty than
↓T
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Income Taxes & Consumption
Schedule
● Fiscal policy
♦ Government’s plan for spending & taxation
♦ Shift AD in desired direction
● Disposable income (DI = Y-T)
♦ Where Y = Real GDP and T = Taxes
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Income Taxes & Consumption
Schedule
● Tax increase
♦ C f(x) and expenditure schedule shift downward
♦ Equilibrium GDP (on the demand side) is decreased
● Tax decrease
♦ C f(x) and expenditure schedule shift upward
♦ Equilibrium GDP (on the demand side) is increased
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FIGURE 1. How tax policy shifts
the consumption schedule
Real Consumer Spending
Tax Cut
C
Tax Increase
Real GDP
The Multiplier Revisited
● ∆ in G
♦ Impacts spending directly
■ through G component of C + I + G + X – IM
● ∆ in T
♦ Impacts spending indirectly– through C component
♦ Unlike G, not every dollar is spent, some is saved
♦ So the multiplier is smaller for T than for G
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The Multiplier Revisited
● Multiplier
♦ Reduced by income tax
♦ Income tax reduces the fraction of each dollar of GDP
that consumers actually receive and spend
● Oversimplified multiplier of 1/(1-MPC)
♦ Overstates the economy’s actual multiplier
1. Ignores variable imports
2. Ignores price-level changes
3. Ignores income tax
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The Multiplier Revisited
●
Two ways taxes modify the multiplier analysis:
1. Tax changes have a smaller multiplier effect than
spending changes by gov or others.
2. An income tax reduces the multipliers for both tax
changes and changes in spending.
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The Multiplier Revisited
● Automatic stabilizer: feature of the economy that reduces
its sensitivity to shocks
● Changes in spending components (C, I, G, or X-IM)
occur all the time and they drive GDP up or down by a
multiplied amount.
♦ If the multiplier is smaller → GDP is less sensitive to shocks
and the economy is less volatile
● Ex.: personal income tax
♦ Taxes make DI and thereby C less volatile
■ E.g., If ↑Y, ↑DI less sharply because part of the rise is absorbed by the
gov which helps limits any ↑C
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The Multiplier Revisited
● UI is also an automatic stabilizer
♦ If ↓GDP and ↑UE → UI prevents DI from fallings as
dramatically as earnings
♦ UE can maintain their spending better, so C fluctuates less than
employment does
● Automatic stabilizers act as shock absorbers and
therefore lower the multiplier
♦ Stabilizers (like taxes or UI) work automatically without the
need for gov action
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The Multiplier Revisited
● Gov transfer payments
♦ Payments to individuals and not compensation for
production
♦ Intervene between GDP and DI in exactly the opposite
way from income taxes
■ Add to earned income (rather than subtract from it)
■ Function as negative taxes
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Planning Fiscal Policy
● Expansionary fiscal policy
♦ ↑G, ↓taxes or ↑transfer payments
♦ To close recessionary gap between actual and
potential GDP
● Contractionary fiscal policy
♦ ↓G, ↑taxes or ↓transfer payments
♦ To close inflationary gap between actual and potential
GDP
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Choice: Spending Policy & Tax
Policy
● Any combination of higher spending and lower taxes that
produces the same AD curve leads to the same increases
in real GDP and prices
● So should policy makers use ↑G or ↓T to ↑AD?
♦ How large a public sector do they want?
♦ Conservatives argue for smaller government
■ Reduces taxes during recessions and cut spending during booms
♦ Liberals argue for larger government
■ Increase spending during recessions and raise taxes during booms
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FIGURE 2. Expansionary fiscal policy
D1
S
Price Level
D0
Rise in
Price level
A
E
D1
S
Rise in
real GDP
D0
Real GDP
72
Some Harsh Realities
● Why can’t fiscal policy drive GDP to its fullemployment level?
● C, I, and X-IM schedules shift abruptly with changes in
expectations, technology, and events abroad, etc.
● Multipliers are unknown
● What is the full-employment level of GDP?
● Time lag between fiscal policies and their impact on
spending
● Congress members (not economists) enact “political”
fiscal policies
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Some Harsh Realities
● Should policy makers work to push UE lower?
♦ ↑G or ↓T will ↑deficits; What are the LR costs of
running large budget deficits?
♦ How large will the inflationary cost be?
● If costs are large, then gov may be hesitant to use fiscal
policy to fight recessions.
● “Supply-side” economics
♦ Battle UE without sparking inflation
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Idea Behind Supply-Side Tax
Cuts
● Certain types of tax cuts
♦ Shift AS out which can ↓inflation and ↑real GDP
♦ Raise the returns to working, saving and investing
■ If people respond → ↑SL and ↑SK
● Supply-siders typically advocate tax cuts on:
♦ Personal income
♦ Income from savings
♦ Capital gains
♦ Corporate income
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
FIGURE 3. The goal of supply-side
tax cuts
S0
D
S1
Price Level
A
B
D
S0
S1
Real GDP
76
FIGURE 4. A successful supply-side
tax reduction
D1
S0
D0
S1
A
Price Level
E
A successful
supply-side tax
cut will shift both
AD and AS.
C
D1
D0
S0
S1
Real GDP
77
Idea Behind Supply-Side Tax
Cuts
● Some complications and undesirable side effects
♦ Small magnitude of supply-side effects
■ People may not save more in response to tax incentives.
■ Charles Schultz: “There’s nothing wrong with supply-side
economics that division by 10 couldn’t cure.”
♦ Demand-side effects
■ People may work more but they will certainly spend more.
● Figure 5 (rather than Figure 4) may better represent the
impact of supply-side policies on AD and AS.
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FIGURE 5. A more pessimistic view
of supply-side tax cuts
D1
S0
D0
Price Level
E
S1
A supply-side tax cut
may shift AD much
more than AS.
C
D1
Inflation now rises as
it did under “demandside” fiscal stimulus
in Figure 2.
D0
S0
S1
Real GDP
79
Idea Behind Supply-Side Tax
Cuts
● Further complications
♦ Problems with timing
■ I incentives are the most promising supply-side tax cuts but
it may take years before we see the impact on GDP.
♦ Effects on income distribution
■ Reductions in personal income-tax rates and capital gains
taxes increase income inequality.
♦ Losses of tax revenue
■ Tax cuts raise the budget deficit.
● 15 years to overcome the deficits created by Reagan’s tax cuts
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Idea Behind Supply-Side Tax
Cuts
● Effectiveness of supply-side tax cuts?
♦ Tax cuts to raise business I – have the greatest impact
♦ Increase AS more slowly than AD
■ Leads to faster economic growth in LR but is not a
substitute for SR stabilization policy
♦ Demand-side effects overwhelm supply-side effects in
SR
♦ Likely to widen income inequalities
♦ Lead to larger budget deficits
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Great Fiscal Stimulus Debate of
2009-10
● Both political parties wanted to stimulate the economy in
2009 but Republicans wanted less G and more T cuts.
● Democrats argued that the supply-side effects of
Republican-proposed tax cuts are small and uncertain
and that the economy has too little AD (not too little AS).
● Republicans countered that business tax incentives are
the best way to spur LR job creation and that the fiscal
multiplier is small or even zero.
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