Chapter
16: Supply-Side Policy--Short-Run Options
Thusfar in our policy discussions we have looked at fiscal and monetary policies, both of which are designed to shift the demand curve. In this chapter, and in chapter 17 we will examine policies designed to shift the aggregate supply curve in the short run to deal with business cycles, and in the long run to encourage economic growth and raise living standards.
I. Why shift AS?
A. Stagflation
In the mid 1970s both inflation and unemployment rose at the same time. This situation is known as stagflation. This cannot occur with an aggregate demand shift. If AD increases, then inflation rises but unemployment falls (because output rises). If AD falls, then inflation falls but unemployment rises. The explanation lies with the aggregate supply curve. If the AS supply curve shifts left (decreases) due to costs increases (like with the rising oil prices in the 1970s), we see both higher prices and lower output (higher unemployment):
Also, if we are near the vertical portion of the AS curve, increases in AD will impact mostly prices and not output:
Stagflation creates a big problem for policy makers: Do they increase AD to increase output (and employment) but make inflation worse? Or do they fight inflation by decreasing AD, but making unemployment worse?
B. The Phillips Curve
As long as the AS curve is upward sloping, changes in AD involve a tradeoff between two undesirable outcomes: higher inflation or higher unemployment:
This tradeoff was first developed by economist A.W. Phillips, as is known as the Phillips curve:
This relationship guided fiscal and monetary policy in the 1960s and 1970s. But with stagflation in the 1970s it became clear that we could experience both high unemployment and high inflation. Also in the past 5 years we have enjoyed both low inflation and low unemployment.
Shifting the AS to the right improves the Phillips curve tradeoff and is the best antidote for stagflation. How might the government engineer a shift in AS?
II. How do we shift AS?
Supply-side economics deals with ways to increase aggregate supply so the economy can enjoy both economic growth and low inflation. President Reagan was a fan of supply-side policies in the 1980s, so supply-side economics is also knwon as "Reaganomics." When President Bush was opposing Reagan for the Republican nomination in 1980, he call supply side economics "Voodoo economics," a phrase that came back to haunt him almost as much as "Read my lips, 'no new taxes.'"
There are four potential ways government policy can influence the AS curve.
Tax policy
We saw in chapter 11 that tax cuts were part of fiscal policy, designed to shift the AD curve. Under fiscal policy all that matters is the size of the tax cut, not how it is accomplished.
Supply-side policy is more concern with the incentives built in the tax system that encourage working and invesment. They are interested in the type of taxes levied as well as the tax rate.
Low marginal income tax rates allow people to keep more of what they earn, perhaps encouraging them to work more hours. This would increase AS.
Low tax rates on profits as well as special investment tax breaks encourage investment in plants and equipment that also increase aggregate supply.
How do these tax cuts impact the federal budget? Supply-siders argued that by increasing work and investment incentives, a tax cut could actually INCREASE tax revenue because the taxes would be levied on larger incomes and profits. Arthur Laffer, one of Reagan's advisors, demonstrated this relationship with the Laffer curve:
If tax rates are above C, then a tax cut will actually increase revenue. Unfortunately in 1982 tax rates were well below C, and revenues fell sharply.
Reagan tax cuts certainly played a role in the economic expansion of the 1980s, but this could be due to the impact of the tax cuts on aggregate demand. The tax cuts also contributed to large deficits.
Human capital investment
Encouraged an increase in hours worked through tax incentives is one way to increase AS. Another way to to increase the quality of the workforce. This set of skills and knowledge is known as human capital. By increasing the skills of the labor force, structural unemployment falls, causing AS to increase. Also, skills increase labor productivity (the amount of output produced per worker per hourer), also increasing AS.
How can government policy increase human capital? Some politicians favor greater investment in education, while others support on-the-job training. 1996 welfare reform allowed for education and training programs designed to increase the human capital of those on public assistance.
Deregulation
There is no doubt that government regulation increases the costs of production. Environmental and safety regulation, mandatory compensation and benefits regulation, consumer protection regulations, higher prices in regulated industries--all of these costs add up, and reducing them would increase AS.
However, it is import to note that relaxing some of these restrictions could be costly too. Air pollution contributes to health problems which result in higher medical costs and absenteeism for firms. A lack of maternity leave may cause some women to quit, and retraining workers is costly. No one would suggest that the government stop regulated the safety of drugs or automobiles.
Supply-siders argue that there is too much regulation, in the past 25 years they have supported the deregulation of the financial sector, the airlines, and communications. They currently support the deregulation of the electric/natural gas utilities.
Infrastructure investment
Recall that infrastructure refers to the transportation, communication, and legal networks that allow markets to function. The U.S. infrastructure is far superior to most nations, but improvements could increase aggregate supply: more roads and airports would reduce travel time, fiber optic networks allow for faster internet connections. This time savings may be devoted to other productive activities.
Infrastructure investment also increases aggregate demand. When the goverment builds roads, they hire engineers and construction firms, who hire workers and buy cement..., causing the multiplier effect to occur.
Government infrastructure spending declined throughout the 1970s and 80s (as a % of GDP), and some argue that this slowdown contributed to a slowdown in the growth of labor productivity during the same period.
III. Do Supply-Side Policies Work?
Economists and other policy makers still debate this question. However, since the major deregulations in the 1970s, and 1980s the U.S. has experienced two very long economic expansions, interrupted by only a brief and mild recession. At the same time, inflation has been fairly low as well.
Supply-side economics is enjoying a resurgence in popularity with the Republicans in power in 2001. For example in a March 2001 interview, Senate majority leader Trent Lott argued that cutting the capital gains tax will actually increase revenue by encouraging investment and growth. That argument is strait from the Laffer curve. Also, the Bush tax plan calls for cutting marginal rates over time--another supply-side move.
One problem in evaluating supply vs. demand-side policies is that an observed increase in real GDP may be due to an increase in AS or an increase
Thusfar in our policy discussions we have looked at fiscal and monetary policies, both of which are designed to shift the demand curve. In this chapter, and in chapter 17 we will examine policies designed to shift the aggregate supply curve in the short run to deal with business cycles, and in the long run to encourage economic growth and raise living standards.
I. Why shift AS?
A. Stagflation
In the mid 1970s both inflation and unemployment rose at the same time. This situation is known as stagflation. This cannot occur with an aggregate demand shift. If AD increases, then inflation rises but unemployment falls (because output rises). If AD falls, then inflation falls but unemployment rises. The explanation lies with the aggregate supply curve. If the AS supply curve shifts left (decreases) due to costs increases (like with the rising oil prices in the 1970s), we see both higher prices and lower output (higher unemployment):
Also, if we are near the vertical portion of the AS curve, increases in AD will impact mostly prices and not output:
Stagflation creates a big problem for policy makers: Do they increase AD to increase output (and employment) but make inflation worse? Or do they fight inflation by decreasing AD, but making unemployment worse?
B. The Phillips Curve
As long as the AS curve is upward sloping, changes in AD involve a tradeoff between two undesirable outcomes: higher inflation or higher unemployment:
This tradeoff was first developed by economist A.W. Phillips, as is known as the Phillips curve:
This relationship guided fiscal and monetary policy in the 1960s and 1970s. But with stagflation in the 1970s it became clear that we could experience both high unemployment and high inflation. Also in the past 5 years we have enjoyed both low inflation and low unemployment.
Shifting the AS to the right improves the Phillips curve tradeoff and is the best antidote for stagflation. How might the government engineer a shift in AS?
II. How do we shift AS?
Supply-side economics deals with ways to increase aggregate supply so the economy can enjoy both economic growth and low inflation. President Reagan was a fan of supply-side policies in the 1980s, so supply-side economics is also knwon as "Reaganomics." When President Bush was opposing Reagan for the Republican nomination in 1980, he call supply side economics "Voodoo economics," a phrase that came back to haunt him almost as much as "Read my lips, 'no new taxes.'"
There are four potential ways government policy can influence the AS curve.
Tax policy
We saw in chapter 11 that tax cuts were part of fiscal policy, designed to shift the AD curve. Under fiscal policy all that matters is the size of the tax cut, not how it is accomplished.
Supply-side policy is more concern with the incentives built in the tax system that encourage working and invesment. They are interested in the type of taxes levied as well as the tax rate.
Low marginal income tax rates allow people to keep more of what they earn, perhaps encouraging them to work more hours. This would increase AS.
Low tax rates on profits as well as special investment tax breaks encourage investment in plants and equipment that also increase aggregate supply.
How do these tax cuts impact the federal budget? Supply-siders argued that by increasing work and investment incentives, a tax cut could actually INCREASE tax revenue because the taxes would be levied on larger incomes and profits. Arthur Laffer, one of Reagan's advisors, demonstrated this relationship with the Laffer curve:
If tax rates are above C, then a tax cut will actually increase revenue. Unfortunately in 1982 tax rates were well below C, and revenues fell sharply.
Reagan tax cuts certainly played a role in the economic expansion of the 1980s, but this could be due to the impact of the tax cuts on aggregate demand. The tax cuts also contributed to large deficits.
Human capital investment
Encouraged an increase in hours worked through tax incentives is one way to increase AS. Another way to to increase the quality of the workforce. This set of skills and knowledge is known as human capital. By increasing the skills of the labor force, structural unemployment falls, causing AS to increase. Also, skills increase labor productivity (the amount of output produced per worker per hourer), also increasing AS.
How can government policy increase human capital? Some politicians favor greater investment in education, while others support on-the-job training. 1996 welfare reform allowed for education and training programs designed to increase the human capital of those on public assistance.
Deregulation
There is no doubt that government regulation increases the costs of production. Environmental and safety regulation, mandatory compensation and benefits regulation, consumer protection regulations, higher prices in regulated industries--all of these costs add up, and reducing them would increase AS.
However, it is import to note that relaxing some of these restrictions could be costly too. Air pollution contributes to health problems which result in higher medical costs and absenteeism for firms. A lack of maternity leave may cause some women to quit, and retraining workers is costly. No one would suggest that the government stop regulated the safety of drugs or automobiles.
Supply-siders argue that there is too much regulation, in the past 25 years they have supported the deregulation of the financial sector, the airlines, and communications. They currently support the deregulation of the electric/natural gas utilities.
Infrastructure investment
Recall that infrastructure refers to the transportation, communication, and legal networks that allow markets to function. The U.S. infrastructure is far superior to most nations, but improvements could increase aggregate supply: more roads and airports would reduce travel time, fiber optic networks allow for faster internet connections. This time savings may be devoted to other productive activities.
Infrastructure investment also increases aggregate demand. When the goverment builds roads, they hire engineers and construction firms, who hire workers and buy cement..., causing the multiplier effect to occur.
Government infrastructure spending declined throughout the 1970s and 80s (as a % of GDP), and some argue that this slowdown contributed to a slowdown in the growth of labor productivity during the same period.
III. Do Supply-Side Policies Work?
Economists and other policy makers still debate this question. However, since the major deregulations in the 1970s, and 1980s the U.S. has experienced two very long economic expansions, interrupted by only a brief and mild recession. At the same time, inflation has been fairly low as well.
Supply-side economics is enjoying a resurgence in popularity with the Republicans in power in 2001. For example in a March 2001 interview, Senate majority leader Trent Lott argued that cutting the capital gains tax will actually increase revenue by encouraging investment and growth. That argument is strait from the Laffer curve. Also, the Bush tax plan calls for cutting marginal rates over time--another supply-side move.
One problem in evaluating supply vs. demand-side policies is that an observed increase in real GDP may be due to an increase in AS or an increase
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