9 9 Demand-Side Equilibrium: Unemployment or Inflation?

82
9 Demand-Side Equilibrium: Unemployment or Inflation?

Transcript of 9 9 Demand-Side Equilibrium: Unemployment or Inflation?

9

Demand-Side Equilibrium: Unemployment or

Inflation?

● 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

● 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

ContentsContents

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Real World Puzzle: Why does the Market Permit Unemployment?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.

● 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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● 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

● 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

The Meaning of Equilibrium GDPThe Meaning of Equilibrium GDP

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● 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

● 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

The Meaning of Equilibrium GDPThe Meaning of Equilibrium GDP

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The Mechanics of Income DeterminationThe 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

● 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

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

FIGURE 1. Construction of the Expenditure Schedule

FIGURE 1. Construction of the Expenditure Schedule

G = $1,300

I = $900

C + I + G

C + I + G + (X – IM)

C + I

C

7,200 6,800 6,400 6,000 5,600

6,000 6,100

4,800

Rea

l E

xpe

nd

itu

re

Real GDP

5,200

3,900

X –IM = –$100

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).

Slope of the expenditure schedule = MPC because I, G, and X-IM are assumed to be constant and do not vary with GDP.

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● 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.

● 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.

The Mechanics of Income DeterminationThe Mechanics of Income Determination

TABLE 2. The Determination of Equilibrium Output

TABLE 2. The Determination of Equilibrium Output

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● 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.

● 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.

The Mechanics of Income DeterminationThe Mechanics of Income Determination

FIGURE 2. Income-Expenditure Diagram

FIGURE 2. Income-Expenditure Diagram

Spending exceeds output

Output exceeds spending

Equilibrium

6,000

Rea

l Exp

end

itu

re

45°

5,200 5,600 6,000 6,400 6,800 7,200 0

4,800

5,600

6,400

6,800

7,200

Real GDP 4,800

5,200

C + I + G + (X – IM)

E

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.

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● 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

● 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

The Aggregate Demand CurveThe Aggregate Demand Curve

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● 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.

● 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.

The Aggregate Demand CurveThe Aggregate Demand Curve

FIGURE 3. The Effect of the Price Level on Equilibrium AD

FIGURE 3. The Effect of the Price Level on Equilibrium AD

Y2

Pri

ce L

evel

Real GDP

C0 + I + G + (X–IM)

Y0 Y1

45

45

C2 + I + G + (X–IM)

E0

C1 + I + G + (X–IM) E1

Change in P level Movement along AD curve

Real GDP

Rea

l E

xpen

dit

ure

E0

AD

E1

E2

Y1 Y2 Y0

P0

P2

P1

E2

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The Aggregate Demand CurveThe 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.

● 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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● 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.

● 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.

Demand-Side Equilibrium and Full EmploymentDemand-Side Equilibrium and Full Employment

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● If equil GDP > full employment level of GDP → economy has inflation.

● If equil GDP < full employment level of GDP → economy has unemployment.

● If equil GDP > full employment level of GDP → economy has inflation.

● If equil GDP < full employment level of GDP → economy has unemployment.

Demand-Side Equilibrium and Full EmploymentDemand-Side Equilibrium and Full Employment

FIGURE 4. A Recessionary GapFIGURE 4. A Recessionary Gap

Recessionary gap

C + I + G + (X – IM)

45°

45°

Potential GDP

7,000

Rea

l Exp

end

itu

re

Real GDP

6,000

E

F

B

Full emp = $7,000B and equil GDP = $6,000B.

Here exp is too low to have full emp. Happens if C, I, G, or X are weak or P level is “too high.”

UE occurs because there isn’t enough output demanded to keep entire L force working.

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 GapFIGURE 5. An Inflationary Gap

Inflationary gap

45°

45°

Potential GDP

8,000

Rea

l Exp

end

itu

re

Real GDP

7,000

C + I + G + (X – IM)

F

B E

Full emp = $7,000B and equil GDP = $8,000B.

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.

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The Coordination of Saving and InvestmentThe 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.

● 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 InvestmentThe 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.

● 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 AnalysisChanges 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.

● 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.

TABLE 3. Total Expenditure after a $200 Billion Increase in Investment

TABLE 3. Total Expenditure after a $200 Billion Increase in Investment

FIGURE 6. Illustration of the Multiplier

FIGURE 6. Illustration of the Multiplier

Rea

l E

xpen

dit

ure

45

$200 billion

6,800 0 6,000 Real GDP (or Y)

C + I1 + G + (X – IM)

C + I0 + G + (X – IM) E1

E0

Multiplier = ∆Y/∆I = $800/$200 = 4

Or multiplier = 1/(1-MPC) = 1/(1-0.75) = 4

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Changes on the Demand Side: Multiplier AnalysisChanges 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

● 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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● ∆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.

● ∆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.

The Multiplier Is a General ConceptThe Multiplier Is a General Concept

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The Multiplier and the Aggregate Demand CurveThe 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).

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).

FIGURE 7. Two Views of the Multiplier

FIGURE 7. Two Views of the Multiplier

45

C + I1 + G + (X – IM )

$200 billion

C + I0 + G + (X – IM )

0 6,000

100 Pri

ce L

evel

Rea

l Exp

end

itu

re

6,800

6,800 6,000

Real GDP

(I = $1,100) D1

D1

(I = $900) D0

D0

E0

E0

E1

E1

Supply-Side Equilibrium: Unemployment and

Inflation?

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● 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

● 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

ContentsContents

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The Aggregate Supply CurveThe 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

● 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

FIGURE 1. An Aggregate Supply Curve

FIGURE 1. An Aggregate Supply Curve

Pri

ce L

evel

Real GDP

S

S

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Why does the Aggregate Supply Curve have a Positive Slope?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

● 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 CurveShifts 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

● 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 CurveShifts 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.

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.

FIGURE 2. A Shift of the Aggregate Supply Curve

FIGURE 2. A Shift of the Aggregate Supply Curve

S1

S1 (higher wages)

S0

S0 (lower wages)

100

6,000

Pri

ce

Lev

el

5,500 Real GDP

A B

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Equilibrium of Aggregate Demand and SupplyEquilibrium 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.

● 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.

FIGURE 3. Equilibrium Real GDP and the Price Level

FIGURE 3. Equilibrium Real GDP and the Price Level

Pri

ce L

evel

90

130

110

80

120

D

D S

S

100

6,400 6,800 5,200 5,600 6,000 Real GDP

E

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● 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

● 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

Inflation and the MultiplierInflation and the Multiplier

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● 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.

● 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.

Inflation and the MultiplierInflation and the Multiplier

FIGURE 4. Inflation and the MultiplierFIGURE 4. Inflation and the Multiplier

Real GDP (Y)

6,8006,400

100

120

6,000

$800billion

80

110

130

90

NOTE: Amounts are in billions of dollars per year.

Pri

ce L

evel (Y

)

D1

D1

D0

D0

S

S

E0

E1

Assume I rises by $200B. This raises total expenditure (or Q of AD) by $800 (= $200B x multiplier of 4).

If AS were horizontal → multiplier = 4 and equil GDP would rise to $6,800B.

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).

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● 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!

● 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!

Recessionary and Inflationary Gaps RevisitedRecessionary and Inflationary Gaps Revisited

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Adjusting to a Recessionary GapAdjusting 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!

● 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!

FIGURE 5. The Elimination of a Recessionary Gap

FIGURE 5. The Elimination of a Recessionary Gap

100

6,000

Recessionary gap

S0

S0

D

D

Potential GDP

Pri

ce L

evel

7,000

Real GDP

E

S1

S1

F

B

Recessionary gap = $1,000B.

Weak spending and UE at pt E.

Weak labor markets put pressure on wages to fall.

Falling wages shift AS outward which lowers prices.

Falling prices stimulate C and net X.

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● 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.

● 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.

Adjusting to a Recessionary GapAdjusting to a Recessionary Gap

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● 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?

● 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?

Adjusting to a Recessionary GapAdjusting to a Recessionary Gap

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● 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.

● 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.

Adjusting to a Recessionary GapAdjusting to a Recessionary Gap

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Adjusting to a Recessionary GapAdjusting 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%

● 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 GapAdjusting 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?

● 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 GapAdjusting 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.

● 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 GapAdjusting 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!

● 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!

FIGURE 6. The Elimination of an Inflationary Gap

FIGURE 6. The Elimination of an Inflationary Gap

S1

S1

S0

S0

D

D

Real GDP

Pri

ce

Le

ve

l

E

Inflationary gap

Potential GDP

F

B

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Adjusting to an Inflationary GapAdjusting 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.

● 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 GapAdjusting 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.

● 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 ShockStagflation 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.

● 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.

FIGURE 7. Stagflation from an Adverse Shift in AS

FIGURE 7. Stagflation from an Adverse Shift in AS

42.2

35.4

3,870

Pri

ce

Le

ve

l

3,900

Real GDP

D

D

S1

S1

S0

S0

A

E

In 1973, ↑P of oil x 4 → ↓real GDP by 1% and ↑P level by 19%.

Data from 1973

Managing Aggregate Demand:

Fiscal Policy

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● 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

● 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

ContentsContents

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Great Fiscal Stimulus Debate of 2009-10Great 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

● 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 ScheduleIncome 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

● 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 ScheduleIncome 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

● 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

FIGURE 1. How tax policy shifts the consumption scheduleFIGURE 1. How tax policy shifts the consumption schedule

Real GDP

Rea

l Con

sum

er S

pend

ing

C

Tax Increase

Tax Cut

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The Multiplier RevisitedThe 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

● ∆ 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 RevisitedThe 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

● 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 RevisitedThe 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.

● 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 RevisitedThe 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

● 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 RevisitedThe 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

● 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 RevisitedThe 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

● 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 PolicyPlanning 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

● 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 PolicyChoice: 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

● 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

72

Real GDP

Pric

e Le

vel

D0

D0

S

S

D1

D1

A

E

Rise in

real GDP

Rise in

Price level

FIGURE 2. Expansionary fiscal policy

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Some Harsh RealitiesSome Harsh Realities

● Why can’t fiscal policy drive GDP to its full-employment 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

● Why can’t fiscal policy drive GDP to its full-employment 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 RealitiesSome 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

● 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 CutsIdea 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

● 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

76

Real GDP

Pric

e Le

vel

D

DS0

S0

A

S1

S1

B

FIGURE 3. The goal of supply-side tax cuts

77

Real GDP

Pric

e Le

vel

D0

D0

S0

S0

E

S1

S1

D1

D1

A

C

FIGURE 4. A successful supply-side tax reduction

A successful supply-side tax cut will shift both AD and AS.

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Idea Behind Supply-Side Tax CutsIdea 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.

● 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.

79

Real GDP

Pric

e Le

vel

D0

D0

S0

S0

E

S1

S1

D1

D1

C

FIGURE 5. A more pessimistic view of supply-side tax cuts

A supply-side tax cut may shift AD much more than AS.

Inflation now rises as it did under “demand-side” fiscal stimulus in Figure 2.

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Idea Behind Supply-Side Tax CutsIdea 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

● 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 CutsIdea 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

● 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 2009-10Great 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.

● 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.