Expectations and Macroeconomic Stabilization Policies Adaptive and Rational

Expectations and Macroeconomic Stabilization Policies Adaptive and Rational Expectations

Adaptive Expectations • Adaptive Expectations – Expectations depend on past experience only. • Expectations are a weighted average of past experiences. • Expectations change slowly over time.

Rational Expectations • Expectations that are based on all available information past and present as well as on a basic understanding of how the economy works. • The theory of rational expectations states that expectations will not differ from optimal forecasts using all available information.

Rational Expectations • Rational expectations mean that expectations will be identical to optimal forecasts (the best guess of the future) using all available information, but…. . – It should be noted that even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate.

Non-rational Expectations • There are two reasons why an expectation may fail to be rational: – People might be aware of all available information but find it takes too much effort to make their expectation the best guess possible. – People might be unaware of some available relevant information so their best guess of the future will not be accurate.

Rational Expectations: Implications • If there is a change in the way a variable moves, there will be a change in the way expectations of this variable are formed. • Therefore, the forecast errors of expectations will be random with a mean of zero, unrelated to those made in previous periods, revealing no discernable pattern, and have the lowest variance compared to other forecasting methods.

The New Classical vs. New Keynesian Debate

The Fooling Model • Components – Aggregate Supply • Production function – Determines the relationship between employed factors of production and total output. • Labor Market – Determines employment of labor and the real wage. – Aggregate Demand

The Fooling Model • The distinctive features of this model are: – All markets clear. • The adjustment process of “market clearing” is the essence of the model. • The market is cleared when it is in equilibrium. • Equilibrium is a state of rest where there are no forces causing change or there are equal opposing forces. – Business cycles can occur only if workers have imperfect information about prices and as a result inaccurately perceive price level changes.

Equilibrium P LAS SAS 0(Pe 0) At point E 0, the model is in longrun and short-run equilibrium. AD = SAS = LAS P 0 0 E 0 YN The equilibrium price level is P 0 and the full employment equilibrium output is YN AD 0 Y

Employment • Assumptions: – Labor demand is determined by the real wage. – When the actual price level changes, workers’ price expectations do not change. – Labor supply is determined by the expected real wage; that is, the nominal wage divided by the price level expected by the workers.

The Fooling Model W/P Ls(W/Pe) W 1/P 0 W 0/P 0 W 1/P 1 0 P LAS SAS 0(Pe 0) D E 0 C P 1 C L 0 L 1 Employment P 0 Ld(W/P) L E 0 AD 1 AD 0 0 YN Y 1 Real GDP Y

AD-AS Model • The initial equilibrium exists at E 0. – At E 0, Y equals YN and P equals P 0. • The increase in aggregate demand shifts the aggregate demand curve from AD 0 to AD 1. – The price level rises from P 0 to P 1, causing the real wage to fall from W 1/P 0 to W 1/P 1. – Output increases from YN to Y 1. • The new equilibrium exists at C. – At C, Y equals Y 1 and P equals P 1.

Employment • The increase in aggregate demand raises the actual price level and reduces the actual real wage, encouraging firms to hire more workers. – The workers do not realize that the real wage has fallen. As a result, they work more. • At L 1, the real wage equals W 1/P 1 while the nominal wage paid to the workers is W 1/P 0. • The workers supply L 1 labor, moving up the labor supply curve to point D.

The Fooling Model W/P Ls(W/Pe) W 1/P 0 W 0/P 0 W 1/P 1 0 P LAS SAS 0(Pe 0) D E 0 C P 1 C L 0 L 1 Employment P 0 Ld(W/P) L E 0 AD 1 AD 0 0 YN Y 1 Real GDP Y

Fooling Model: Long Run Adjustment SAS(Ls(W/P 1)) P SAS(Ls(W/P 0)) When workers realize that the real wage has fallen, they demand a higher nominal wage. P 2 P 1 P 0 D C B The increase in the nominal wage causes the SAS to shift left. A new equilibrium is established at D. AD 1 0 YN Y 1 AD 0 Y

Fooling Model: Long Run Adjustment SAS(Ls(W/P 3)) P P 3 P 2 P 1 P 0 SAS(Ls(W/P 1)) SAS(Ls(W/P 0)) At point D, the real wage has fallen again, causing workers to demand a higher nominal wage. E 3 D C E 0 As nominal wages increase, the SAS shifts left. AD 1 0 YN Y 1 AD 0 Y

Fooling Model: Long Run Adjustment SAS(Ls(W/P 3)) P SAS(Ls(W/P 1)) SAS(Ls(W/P 0)) P 3 P 2 P 1 P 0 Long-run equilibrium is restored at point E 3 D C E 0 At this point, the nominal wage has risen such that W 3/P 3 = W 0/P 0. AD 1 0 YN Y 1 AD 0 Y

Long Run Aggregate Supply • The long-run aggregate supply curve is a vertical line drawn at the natural level of real GDP. – It shows that in the long-run expectations are accurate. – It shows that long run equilibrium in the labor market can be achieved at many different price levels but only a single level of output. – Long-run equilibrium occurs when labor input is the amount voluntarily supplied and demanded at the equilibrium real wage.

Fooling Model: Summary • Business cycles are explained in this model by permitting the actual price level to differ from the price level expected by the workers. • However, when the workers learn they have been fooled, their price expectations rise and they demand a wage sufficient to regain the original real wage. • The SAS curve shifts up and to the left until output has returned to YN. • The model demonstrates that in the long run shifts in aggregate demand have no long-run effect on real GDP.

Rationale Behind the Fooling Model • Friedman claims that firms have more accurate information than workers because they need to know only a small number of prices of particular products and can monitor them continuously. • Workers, however, are interested in a wide variety of prices and have insufficient time to keep careful track of them.

Criticisms of the Fooling Model • It is unlikely that workers would be fooled for long because: – Workers buy many goods and would notice quickly when their prices rose. – Expectational errors would be corrected quickly because information about price level changes are readily available from the government and the media. – If a periods of high real GDP were always accompanied by an increase in the price level, workers would learn to predict rising prices when production was high and jobs were plentiful.

Friedman-Lucas Model • Assumptions: – Markets clear – Information is imperfect – Expectations are rational • Expectations that are based on all available information past and present as well as on a basic understanding of how the economy works.

Friedman-Lucas Model • The Model: – Each firm in the economy produces in very competitive markets. • The firm has no pricing power. – Each firm knows the price of what it produces, but does not know about the prices of other products. • This imperfect information leads to confusion about changes in the overall price level and changes in relative prices that affect the slope of the short-run supply curve.

Friedman-Lucas Model • The Model: – The amount of output a supplier chooses to produce depends on relative prices. • If the price of his output is high compared to other prices, he is motivated to work hard and produce more. • If the price of his output is low compared to other prices, he prefers more leisure. – When the supplier makes his decision about how much to produce, he knows the price of his output and forms his expectations about prices of the other goods available using rational expectations.

Friedman-Lucas Model • Let all prices rise. – If past movements in the firm’s price have always been accompanied by similar movements in the prices of other firms, the owner will expect relative prices to remain unchanged and will not produce more. – If the firm’s price has experienced unique price movements compared to other firms, the owner may conclude that relative prices have changed, and may produce more or less.

Friedman-Lucas Model • Produce More – If the supplier determines that his price rose by more than other prices, he produces more. • Produce Less – If the supplier determines that his price rose by less than other prices, he produces less. • The short-run aggregate supply curve can be written as: Y = YN + h(P - Pe)

Output and Price Expectations • Y = YN + h(P - Pe) – P > Pe , • If P > Pe, the supplier works harder, Y rises. – P < Pe • If P < Pe, the supplier works less, Y falls. – P = Pe • If P = Pe, there is no change so Y = YN

Friedman-Lucas Model P LAS P 1 The Friedman-Lucas supply curve is fixed in position by the price expectations of workers. SAS 2(Pe 1) Real GDP can rise above YN in the blue area only when the actual price level rises above the expected price level. SAS 1(Pe 0) P 0 0 YN Y An increase in the expected price level shifts the curve up from SAS 1 to SAS 2.

Implications of the Model • The major contribution of Lucas’s model is the conclusion that the supply response will be high for firms that have previously experienced unique price movements and low for firms that have experienced price movements that mirror the aggregate economy.

Implications of the Model: Business Cycle • Lucas also concluded that the supply response would be higher in countries like the USA where inflation had been relatively stable, making unique price movements in individual prices easier to discern. – This means that smaller changes in the price level lead to larger changes in output and as a result a bigger cyclical response. • The SAS in the USA is more elastic or flatter than the SAS in other countries.

Implications of the Model: Macro Stabilization • According to the rational expectations hypothesis, monetary policy actions that individuals and firms anticipate have no effect on real variables such as output and employment. – This is known as the “policy ineffectiveness proposition. ” • Only unanticipated policy actions that people cannot predict in advance can influence real GDP and employment.

Policy Ineffectiveness Proposition • Let expectations of the price level, Pexp, depend in part on their expectation of how the government will change macroeconomic policy. • Also assume that people can anticipate government policy with a great deal of accuracy; ie. they know the policy rule.

Policy Ineffectiveness Proposition • Expansionary monetary policy actions cause an increase in aggregate demand. • If people correctly forecast those policy actions, then they fully anticipate the change in the price level that the actions will induce. • As price expectations change, wage demands change, causing an offsetting change in aggregate supply.

Policy Ineffectiveness Proposition AS 2 P AS 1 Rational expectations cause offsetting changes in AD and AS. P rises but Y remains constant. P 2 P 1 0 AD 2 AD 1 Y 1 Anticipated Policy Changes Y

Unanticipated Policy Changes • If people do not correctly forecast the government’s policy actions, then they do not correctly forecast the change in the price level induced by the policy change. • In this case, as the price level rises output increases along the aggregate supply curve.

Unanticipated Policy Actions • Expansionary monetary policy actions cause a rightward shift in the aggregate demand curve. • If people do not correctly forecast those policy actions, then they do not correctly forecast the change in the price level induced by the policy change. • As the price level rises, output increases along the SRAS.

Unanticipated Policy Actions AS 1 P Only unanticipated policy changes result in a change in output. In this case, both the price level and output rise. P 2 P 1 0 AD 2 Y 1 Y 2 AD 1 Y Unanticipated Policy Changes

Summary • The new classical analysis suggests that: – An unanticipated increase in the money supply raises the price level and has no effect on real output and employment – Only unanticipated monetary surprises can affect real variables in the short run.

Policy Ineffectiveness: Conclusions • The development of rational expectations ignited a major controversy among economists because the model yielded an implication of policy ineffectiveness that directly challenged the mainstream view that active fiscal and monetary policies are needed to moderate the inherent instability of a market economy.

Policy Ineffectiveness : Conclusions • The research on expectations that followed the introduction of rational expectations increasingly supported the rapid expectations adjustment implied by rational expectations over the sluggish adjustment of adaptive expectations. • This suggested that price misperceptions would disappear so quickly that there was no time for countercyclical policies to be implemented. • Later work, however, found evidence that suggested that both unanticipated monetary policy affected output and employment.

Policy Ineffectiveness : Conclusions • Ultimately, a consensus was reached that the key issue is not how price expectations are formed, but whether changing expectations are really the only important source of output fluctuations. • New approaches rely on underlying sources of friction in the market clearing process to explain business cycles.

Rational Expectations and the Sacrifice Ratio • The amount of output lost during disinflation is known as the sacrifice ratio. • The size of the sacrifice ratio depends in part on how fast price expectations adjust. – If they adjust slowly, the sacrifice ratio will be large, but if they adjust quickly, the ratio will be smaller.

Rational Expectations and the Sacrifice Ratio • The responsiveness of expectations depends on the credibility and reputation of the monetary authority or the Federal Reserve. • The new classical approach argues that announced changes in monetary policy will have no effect on output and employment if the policy is credible. • If the policy announcements lack credibility, inflationary expectations will not fall sufficiently to prevent the economy from experiencing outputemployment costs.

Real Business Cycle Model • The real business cycle model explains business cycles in output and employment as being caused by real shocks. – The origins of the business cycle lie in real shocks rather than monetary shocks. • This suggests that changes in the SAS curve and the IS curve, but not the LM curve, explain cycles. – Real business cycle theorists give the largest role to production function shocks or supply shocks.

Real Business Cycle Shocks • Supply shocks include the following: – – – New production techniques and/or new products New management techniques Changes in the quality of capital or labor Changes in the availability of raw materials Price changes in raw materials • Demand shocks include the following: – Changes in spending and saving decisions – Changes in real government spending • These shocks are assumed to be persistent, tending to fade away smoothly after several years.

Real Business Cycle Features • General Features: – Agents try to maximize their utility or profits, given prevailing resource constraints. – Agents form expectations rationally and do not suffer informational asymmetries. Agents may have difficulty determining whether a shock is temporary or permanent, but information concerning the path of the general price level is publicly available. – Price flexibility ensures continuous market clearing so that equilibrium always prevails.

Real Business Cycle Features • General Features: – Fluctuations in aggregate output and employment are driven by large random changes in the available production technology. – Fluctuations in employment reflect voluntary changes in the number of hours people want to work. – Monetary policy is irrelevant and has no influence on real variables. – There is no distinction between the short-run and the long-run.

Real Business Cycle Model • In real business cycle models, people are assumed to supply more labor when the real wage is high and less labor when the real wage is low. – This propensity to supply more labor during periods of high real wages and less labor during periods of low wages is called intertemporal substitution.

Real Business Cycle Model • As a result of intertemporal substitution, real business cycle models explain unemployment as the voluntary decision of workers to reduce their labor supply in response to temporary declines in their real wage. • This means there is no need for government policy intervention to reduce unemployment associated with recession.

Y Y 1=F(L) Y 1 Y 2=F(L) 2 L 0 0 w/P Y P AS 2 LS w 1/P 1 w 1/P 2 AS 1 1 P 2 2 2 1 P 1 0 LD L 2 L 1 2 AD LD 1 L 0 Y 2 Y 1 Y

Real Business Cycle Model: Adverse Shock • Adverse shocks decrease productivity – The production function shifts down. – The labor demand curve shifts to the left. • The decrease in demand for labor decreases the real wage, causing a voluntary decrease in labor supply along the labor supply curve. • Aggregate supply decreases, causing an increase in the price level given a fixed aggregate demand. • At the new equilibrium the price level rises to P 2, and output falls to Y 2.

Full Employment IS-LM Model FE 2 FE 1 LM 2 r At E 1, the economy is at full employment at the interest rate r 1 and output YN. LM 1 An adverse supply shock reduces full employment output from YN to Y 2, causing the FE line to shift to the left and the price level to rise. r 2 r 1 Given a fixed nominal money supply, the real money supply decreases, causing the LM curve to shift to the left to LM 2. E 2 E 1 IS At the new equilibrium, output equal Y 2 and the interest rate is r 2. 0 Y 2 YN Y Full employment exists at a lower level of Y

Adverse Supply Shock: Conclusions • An adverse supply shock lowers the equilibrium values of the real wage and employment. • At the new equilibrium level of output, the supply shock causes output to fall and interest rates to rise. • The supply shock raises the price level, causing a temporary burst of inflation. • Because interest rates are higher in the new equilibrium, other things remaining the same, saving increases, consumption decreases, and investment decreases.

Real Business Cycles Facts • Real business cycle theory (RBC) is consistent with many of the basic business cycle facts. – Under the assumption that the economy is continuously buffeted by productivity shocks, the RBC approach predicts recurrent fluctuations in aggregate output, which actually occur. – The RBC theory correctly predicts that employment will move procyclically with output. – The theory predicts that real wages will be higher during booms than in recessions, which also occurs.

Real Business Cycles Facts – According to RBC theory, average labor productivity is procyclical; that is, output per worker is higher during booms than during recessions. • This fact is consistent with the RBC theorists’ assumption that booms are periods of beneficial productivity shocks, which tend to raise productivity while recessions are the result of adverse shocks which lower productivity.

Real Business Cycles Facts • With no productivity shocks and a stable production function, the expansion of employment that occurs during booms would tend to reduce average labor productivity because of the principle of diminishing marginal productivity of labor. • Similarly, without productivity shocks, recessions would be periods of relatively higher labor productivity, instead of lower productivity as observed. • RBC theorists argue that the procyclical nature of average labor productivity provides strong evidence of their approach.

Real Business Cycles Facts • A business cycle fact that is not consistent with the RBC theory is that inflation tends to slow during or immediately after a recession. • RBC theory predicts that an adverse productivity shock will both cause a recession and inflation, contrary to business cycle fact.

Real Business Cycle Criticisms • It is hard to measure certain types of real shocks (such as the annual rate of technological change in computer software. ) • Since many real shocks are not readily observable, one can explain any change in output as the result of some unobserved real shock • It is hard to believe that the unemployment that occurred during the Great Depression and similar downturns was voluntary.

Real Business Cycle Criticisms • Labor supply of individual workers does not appear to be sufficiently responsive to intertemporal wage differences to explain the bulk of variation in the use of labor over the business cycle. • If shocks are technological in nature, they are likely to be both industry specific and to average out in the aggregate economy.

Real Business Cycle Defense • Some real shocks such as those due to natural disasters are observable. • Even if it is hard to measure the precise state of technology, we know that there are shocks to technology, even if we can’t measure precisely their size and frequency. • Although one could explain all macroeconomic fluctuations by assuming enough shocks of the right form, the question is whether one can explain a good deal of the variation over time in macro variables based on a limited and plausible set of shocks.

Real Business Cycle Defense • Much of he blame for the Great Depression may be placed on the banking panics of the early 1930 s, the failure of large numbers of banks, the collapse of credit, and the subsequent closing of many business. These events could be viewed as a type of aggregate productivity shock leading to very low real wages.

Real Business Cycle Defense • The reason that workers don’t alter their hours of work in response to changes in their real wages as much as the simple real business cycle models predict is that their employers find it more profitable to require each worker to work full-time. – Therefore, firms lay off workers in downturns rater than permit those they don’t lay off to work less than full time. These layoffs explain the unemployment experienced in recessions. • Industry specific shocks may be correlated and, thereby, produce an aggregate shock.

Efficiency Wage Theory: Overview • The efficiency wage theory explains slow adjustment of wages relative to prices or by stressing the reasons why firms would not want to cut the wage they pay relative to the wage paid by other firms. • According to this theory, a firm believes that the productivity of its workers will increase if the firm pays a higher wage. – Higher wages lead to greater productivity, less shirking, lower turnover as well as attracts higher quality workers and improves morale.

Efficiency Wage Model • Assumptions: – Firms operate in a very competitive environment. – Labor input is multiplied by an efficiency factor that is a measure of effort and depends on the wage rate paid relative to that paid by other firms. • Raising the nominal wage raises labor costs, but also reduces labor cost per unit of output by making workers more efficient. – Firms choose their wages to minimize the wage bill and then choose employment to maximize profit.

Wage Rate and Worker Efficiency e Effort Curve 0 W* W W/e 0 W* W Worker efficiency increases faster than the relative wage up to point W* and more slowly thereafter. As a result, labor cost per unit of efficiency (W/e) reaches a minimum at W*.

Deriving the Short Run Aggregate Supply Curve: Efficiency Wages • Assumptions: – Nominal wages are fixed by whatever technological and institutional factors that determine the efficiency function. – Firms choose their wages to minimize the wage bill and then choose employment to maximize profit. – Consequently, the firm’s reaction to any change in demand for its product is to cut employment while maintaining the nominal wage rate.

Y=F(L) Y Y Y 1 0 w/P L 0 P L 1 Y Y 1 * Y LS U* w 1/P 1* P 1 LD 0 L 1 * LS L 0

Deriving the Modern Aggregate Supply Curve: Efficiency Wages • We begin at the price level P 1 where w 1/P 1* is the efficiency wage. • At w 1/P 1*, the level of unemployment is at the natural rate of U*. – L 1 people are employed and LS minus L 1* are unemployed. • Output equals Y 1 at the price level P 1.

Y=F(L) Y Y Y 2 Y 1 0 w/P L 0 P L 1 L 2 Y Y 2 SAS LS U* w 1/P 1* Y 1 P 2 U w 1/P 2 P 1 LD 0 L 1 * L 2 L 0 Y 1 * Y 2 Y

Deriving the Modern Aggregate Supply Curve: Efficiency Wages • Let the price level increase to P 2. • Since nominal wages do not change, the real wage falls to w 1/P 2. • Firms try to hire more workers while households send fewer workers to the labor market. • Unemployment falls below U*. • Output rises to Y 2 at the price level P 2.

Y=F(L) Y Y Y 2 Y 1 Y 3 0 L 3 L 1 L 2 w/P w 1/P 3 w 1/P 1* L 0 P U Y 3 Y 1 SAS LS U* Y Y 2 P 2 U w 1/P 2 P 1 P 3 LD 0 L 3 L 1 * L 2 L 0 Y 3 Y 1 * Y 2 Y

Deriving the Modern Aggregate Supply Curve: Efficiency Wages • Let the price level decrease to P 3. • Since nominal wages do not change, the real wage rises to w 1/P 3. • Firms reduce employment while households send more workers to the labor market. • Unemployment rises above U*. • Output falls to Y 3 at the price level P 3.

The Modern Aggregate Supply Curve: Efficiency Wages • Summary: – When nominal wages are sticky, a rise in the price level results in higher levels of output, and a fall in the price level results in lower levels of output. – When we plot the price level/output combinations, we get an upward sloping aggregate supply curve. – Nominal wage is constant on any given aggregate supply curve.

The Modern Aggregate Supply Curve: Efficiency Wages • Summary: – When the real wage equals the efficiency wage, unemployment is equal to its natural rate, and the quantity of output produced is called the “natural rate of output. ”

Economic Policy • Unlike the new classical model according to new-Keynesian theory, the labor market may not always be in equilibrium. – When nominal wages are “sticky, ” labor demand can be less than labor supply. – As a result, the economy can experience extended periods when markets do not clear. – Consequently, it is possible for macroeconomic stabilization policies to change the level of output in the short run.

Y Y Y=F(L) 0 w/P L 0 P Y LAS SAS LS w 1/P 1 U* P 1 AD 1 LD 0 L 1 L* L 0 Y 1 Y* Y

The Efficiency Wage Model • We begin at the price level P 1 where w 1/P 1* is the efficiency wage. • At w 1/P 1*, the level of unemployment is at the natural rate of U*. – L 1 people are employed and Ls minus L 1 are unemployed. • Output equals Y 1 at the price level P 1.

Y Y Y=F(L) 0 w/P L 0 P LRAS Y LRAS SRAS LS w 1/P 1* w 1/P 2 P 1 2 1 AD 2 AD 1 LD 0 L 1 L 2 L* L 0 Y 1 Y 2 Y* Y

The Efficiency Wage Model: Aggregate Demand Increase • Let the money supply increase, causing the aggregate demand curve to shift to the right. • The price level rises to P 2, and the real wage falls to w 1/P 2. • Labor demand rises to L 2 while labor supply responds with a lag. • Unemployment falls below the natural rate. • Output rises to Y 2.

Y Y Y=F(L) 0 w/P L 0 P LRAS Y LRAS SRAS LS w 1/P 2 w 1/P 1 P 2 1 2 AD 1 AD 2 LD 0 L 2 L 1 L* L 0 Y 2 Y 1 Y* Y

The Efficiency Wage Model: Aggregate Demand Decrease • Let the money supply contract, causing the aggregate demand curve to shift to the left. • The price level falls to P 2, and the real wage rises to w 1/P 2. • Labor demand falls to L 2 while labor supply rises. • Unemployment rises above the natural rate. • Output falls to Y 2.

The Efficiency Wage Model: The Non. Neutrality of Money • A change in the money supply does not cause all the variables to change in proportion because the nominal wage is slow to adjust. • Rather, the change in the money supply causes a change in production and employment as well as a change in prices. • In this model, the economy adjusts through changes in real variables as well as prices.

Implications • The efficiency wage approach predicts the widely observed phenomenon that workers line up for high paying jobs but firms hire only a few of them, maintaining the high wage in order to be able to pick and choose rather that reduce the wage rate in the face of abundant supply of workers. • The theory also predicts that less productive workers, those whose labor cost per efficiency unit is high, will suffer higher unemployment rates than more productive groups.

Implications • The model explains why we do not use work sharing in the form of fewer hours per week in periods of low demand. Such wage reductions would raise labor cost by cutting the wage income and hence the efficiency of the most productive workers. • Finally, the model explains why a firm may find it profitable to keep wages above the level that balances demand supply, causing a lower rate of job finding and higher unemployment.

Supply Side Fiscal Policy

Supply Side Economics • Supply side economics predicts that a reduction in marginal income tax rates will create an increase in the supply of output, that is, in natural GDP.

Fiscal Policy: Supply Side Transmission Mechanism Inflation Falls Unemployment Falls After-tax Wage Higher Increase in Labor Supply Savings Rise Interest Rates Fall After-tax ROR Rises Investment Rises Aggregate Supply Rises Lower Personal Tax Rates Lower Business Tax Rates Productivity Rises

Fiscal Policy: Supply Side • Expansionary Fiscal Policy – The federal government decreases taxes. • People work more: People save more: Firms invest more. • Aggregate supply increases, unemployment falls, inflation falls.

Tax Cuts: Labor Supply • The decrease in marginal income tax rates encourages people to work more. – People are willing to work more because they now keep more of their wages. • More specifically, they get to keep more of the last dollar earned. – Therefore, the increased labor supply increases output without putting upward pressure on wages.

Tax Cuts: Saving and Investment • Business tax cuts increase business profits. – Higher profits encourage investment in new capital. • Individual tax cuts stimulate household savings. – Increased savings contribute to lower interest rates and increased investment in new capital. • New capital increases productivity, thus, lowering costs and inflationary pressures.

Supply-Side Fiscal Policy Problems • Small Magnitude of the Supply-side Effects. – Savings do not appear to respond to tax incentives. • Demand Side Effects. – People respond to tax cuts by spending more. They may or may not respond by working more. • Timing Problems – The impact of increases in investment spending occur much later as industrial capacity increases.

Supply-Side Fiscal Policy Problems • Effect on Income Distribution – Supply-side tax cuts favor the wealthy. • Tax Cuts Increase the Budget Deficit – But, so do demand-side tax cuts.

Criticisms of Supply Side Economics • Most economists agree with the basic ideas behind supply-side economics, but question the magnitude of the changes that occur as a result of marginal tax decreases. • In particular, the response of labor supply to the decreases in taxes was quite small.