CHAPTER 16: Supply-Side Policy

Introduction to Supply-Side Policy

  • Supply-side policies focus on manipulating the aggregate supply curve for macroeconomic advantages.

  • The significance of the aggregate supply curve is highlighted through:

    • The impact of macro events (natural disasters, pandemics, wars) on the economy.

    • Understanding how aggregate supply affects macro outcomes and how it can be shifted.

  • Objectives of aggregate supply:

    • Achieving full employment.

    • Maintaining price stability.

AGGREGATE SUPPLY

Historical Context:

  • Attention to the supply side heightened during the stagflation of the 1970s (concurrent rise in inflation and unemployment).

    • Example: Inflation jumped from 8.7% to 12.3% (1973-1974) alongside an unemployment rise from 4.9% to 5.6%.

    • Demand-side theories failed to explain this phenomenon since they posit opposite movements in inflation and unemployment.

SHAPE OF THE AGGREGATE SUPPLY CURVE

  • Fiscal and Monetary Policy Objectives: Fulfill full employment and price stability by shifting the aggregate demand curve.

  • Producer responses to aggregate demand shifts can include increases in output, price changes, or combinations of both.

  • The shape of the aggregate supply curve is crucial as it reflects producer response to demand shifts.

Three Views of Aggregate Supply:

  1. Keynesian Aggregate Supply (AS):

    • Depicted by a horizontal AS curve in deep recession; output rises without price increases until capacity (Q*) is reached.

    • When aggregate demand increases, equilibrium GDP expands without inflation until capacity is breached.

  2. Monetarist Aggregate Supply:

    • Represented by a vertical AS curve indicating that output remains at the natural rate regardless of price changes.

    • Aggregate demand shifts affect only prices, not output.

    • Example: If aggregate demand shifts from AD4 to AD5, only prices rise while output remains at the natural unemployment rate (QN).

  3. Hybrid Aggregate Supply:

    • A blend of Keynesian and monetarist views, where the AS curve gently slopes upward in the middle range.

    • This indicates that, near full employment, increased demand raises both prices and output, thus limiting policy effectiveness.

Price Level Dynamics:

  • The upward slope of the AS curve signifies that demand-side policies (stimulus/constraints) create both inflation and unemployment consequences.

THE INFLATION-UNEMPLOYMENT TRADE-OFF

Demand Stimulus:

  • When aggregate demand shifts rightward, outputs increase with accompanying price hikes causing inflation (e.g. from Q6 to Q7).

Demand Restraint:

  • A leftward shift of aggregate demand leads to decreased prices and output, increasing unemployment.

The Phillips Curve:

  • Establishes an inverse relationship between inflation and unemployment; as one rises, the other decreases.

  • Developed by Alban W. Phillips; shows a historical correlation between inflation and unemployment rates.

  • The upward-sloping AS implies the Phillips curve trade-off, where both inflation and unemployment cannot be minimized simultaneously through demand-side policies.

Inflationary Flashpoint:

  • Represents the output level where inflation pressures intensify significantly, delineating a point of increasing costs in achieving lower unemployment.

SHIFTS OF THE AS CURVE

Rightward AS Shifts:

  • Rightward shifts reduce both unemployment and inflation, representing favorable macroeconomic conditions.

  • Examples include shifts in AS from AS1 to AS2 resulting in higher outputs (at E₂) with lower prices.

  • A leftward shift, which results in stagflation, worsens the unemployment-inflation trade-off.

POLICY TOOLS FOR SHIFTING AS CURVE

  • Supply-side policies that influence AS include:

    • Tax incentives: Encouraging savings, investment, and work.

    • Human capital investments.

    • Deregulation and Trade liberalization.

    • Infrastructure development.

TAX INCENTIVES:

  • Traditionally viewed through Keynesian lenses for demand increase but supply-side perspectives emphasize the impact of tax rates on labor supply and production incentives.

  • Tax cuts stimulate production by enhancing incentives to work and invest.

  • The marginal tax rate specifically influences economic choices, affecting labor supply and entrepreneurship.

Investment & Entrepreneurship:

  • High marginal tax rates deter work and investment; thus, lower rates can catalyze economic growth through increased production capacity and job creation.

Tax Elasticity of Supply

  • Measures the responsiveness of quantity supplied to changes in tax rates while generally expected to be positive.

  • Illustrates the varied impacts of tax rate reductions on aggregate supply and economic outcomes.

Human Capital Investment:

  • Focus on upskilling labor to meet evolving job requirements, reducing structural unemployment.

  • Policy tools include enhancing education and training initiatives.

DEREGULATION:

  • Deregulatory measures to lower costs and increase production flexibility enhance aggregate supply shifts to the right.

  • Regulations lead to increased production costs, thus negatively impacting AS.

TRADE BARRIERS:

  • Trade policies, such as tariffs, hinder both product and factor markets, leading to leftward shifts of the AS curve.

  • Lowering trade barriers encourages aggregate supply increases.

Key Terms

  • stagflation The simultaneous occurrence of substantial unemployment and inflation.

  • aggregate supply (AS) The total quantity of output (real GDP) producers are willing and able to supply at alternative price levels in a given time period,

  • Phillips curve A historical (inverse) relationship between the rate of unemployment and the rate of inflation; commonly expresses a trade-off between the two.

  • inflationary flashpoint The rate of output at which inflationary pressures intensify; the point on the AS curve where slope increases sharply.

  • misery index The sum of inflation and unemployment rates.

  • marginal tax rate The tax rate imposed on the last (marginal) dollar of income.

  • investment Expenditures on (production of) new plants, equipment, and structures (capital) in a given time period, plus changes in business inventories.

  • tax rebate A lump-sum refund of taxes paid.

  • tax elasticity of supply the percentage change in quantity supplied divided by the percentage change in tax rates.

  • saving That part of disposable income not spent on current consumption; disposable income less consumption.

  • capital gains tax A tax levied on the profit from the sale of property.

  • human capital The knowledge and skills possessed by the workforce.

  • structural unemployment Unemployment caused by a mismatch between the skills (or location) of job seekers and the requirements (or location) of available jobs.

  • labor productivity Amount of output produced by a worker in a given period of time; output per hour (or day, etc.).

  • transfer payments Payments to individuals for which no current goods or services are exchanged, like Social Security, welfare, and unemployment benefits.

  • infrastructure The transportation, communications, education, judicial, and other institutional systems that facilitate market exchanges.