Professor Bogan ECO 101

Lecture 10

Supply side Economics and Review

Review not covering whole exam (just some
key slides mostly from lectures)
PROCEDURAL ITEMS: Exam March 12
Bring calculator (phone is OK) and straight edge. Do not
program anything related to this course into your device. No texting, no use of
the phone during the exam for anything but the calculator.
We do have lecture Thursday, March 14
 After Great Recession started get Negative
Supply side shock as oil hit all time high

Already Problem from falling home prices reducing wealth

and decreasing consumption and thus AD.
Also lower housing investment
potential GDP reducing AD
AS2
Price AS1
Level
Supply shock made Fed stop
easing summer 2008 (as
AD inflation hit 5%) until Lehman
AD2 collapse in Sept. 2008

Y 2
 The Keynesian vs. Supply-Side
Outlook on AD-AS Equilibrium
 Keynesians are interested in YE off of YF (emphasis on AD and
government moving AD)
 Supply-siders in the position of YF (emphasis on AS) and long

term growth
LRAS1
LRAS2
AD2
AD1
AS2

AS1

YF1 YF2 3
 Factors Shifting AS Rightward

AS shifts rightward from:

 Increased Human Capital
 Increased plant & equipment Increase
Productivity
 Technological change

 Increased hours of labor

4
 The Supply-Side Agenda of the
late ‘70s and the ‘80s —1
1) Abandon stabilization policies that call for discretionary
counter-cyclical changes in government spending and taxes
{aim at long-run growth, not correcting fluctuations}.

2) Permanently restructure the tax system to favor saving and

investment to promote economic growth

r S1
S2

I 5
S, I
 The Supply-Side Agenda —2
3) Reduce government spending so that more resources will be
available to job-creating private businesses.

4) Reduce government regulation so that more business

resources will go into creating new products rather than
complying with government regulations.

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 The Supply-Side Agenda —3
5) Overall — reduce the role of government in the economy to
encourage individual incentives to produce. Reduce marginal
income tax rates to encourage work.

Wage

Work 7
 Supply-Side Tax Cuts
Tax Act of 1981
 Cut income taxes 5% in 1981, 10% in 1982, and 10%
in 1983
 Cut the capital gains tax rate from 28% to 20%
 Allowed IRA’s of $2,000 per worker, tax-free.
Tax Act of 1986
 Reduced the top MTR from 50% to 28%
 Reduced loopholes and exemptions so collected
same revenue with lower rates
 Corporate tax rate was cut from 46% to 34%
Those crazy IRS Agents! What8
will they think of next?
 Issues With Supply-Side
Economics — 1
1) Tax breaks for private saving tend to reduce national saving
National savings = SP + SG
SP = -Co + (1-b)(Y-T)
SG = T - G (if Taxes are net of Transfers)
T=To +tY
If Y is unchanged, then T declines more than SP rises, so
national saving declines.
Supply Side response is belief that increased saving spurs more I
so Y grows enough that taxes collected remain the same
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 Issues With Supply-Side
Economics — 2
2) Tax cuts (at least in the short term) increase AD by a
greater amount than they increase AS
If already have too much AD, when cutting taxes looking to
increase AS won’t stop inflation
But in recessions you want the increased AD from a tax cut
and you may strengthen long run AS to promote growth

3) Greater incentives to save and invest favor the well-to-do.

109
Recent supply side tax cut passed
in 2017
For 2018 reduced personal income tax brackets until 2025
Cut the corporate tax from 35% to 21%

Result: Stimulus to real output but not enough higher income

to offset lower tax rates. Increased the deficit

11
REVIEW
Some aspects of theoretical socialism

THEORETICAL SOCIALISM
Group ownership
Social Responsibility
Consensus on goals
Ethics are state-taught
Group allocation: planned economy, prices set
by the government
Incentive to produce: common good
Role of government is the allocation of most resources
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Pure Socialism vs. Pure Capitalism — 2
Cons of socialism:

1) Inefficiency leads to less overall growth and innovation

2) Collective ownership causes increased bureaucracy

3) Weak incentives to work, or to save and invest hurts economic

growth

4) Lack of information; Few true prices, and bad signals

(wastes resources)
5) No losses or bankruptcies to drive out the inefficient

6) Forced redistribution needs powerful government, which may be

corrupt and often becomes totalitarian, Venezuela 13
 Pure socialism vs. Pure capitalism — 3
Cons of capitalism:

1) In market system, uneven distribution of talents results in

uneven distribution of income

2) Parental influence on children: unequal opportunity

3) May promote materialism at the expense of other values

4) Monopoly power and corporate behaviors not in interest of citizens

may emerge
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 Capitalism & Socialism in the real world
The Welfare State

 Welfare state: an attempt to keep the efficiencies of privately-

owned businesses of market economy, while promoting the
social egalitarian aims of socialism by taxing and
redistributing, but leaving most businesses private
.

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 Socialism in Venezuela
 Price controls: shortages, black markets
 Appropriation and Nationalization of all
foreign based companies, jobs disappear
 Incentives to operate a business, to save or to
invest collapse
 Attempts to force equality bring
totalitarianism (Bribery and corruption)
 As real economy collapses, prints money
A million percent+ inflation for 2018-19
16
 Results in Venezuela
 Income per person now at 1950s levels (fell about 50%
past decade)
 93% say cannot afford food they need, ¾ have lost weight
 People starving, 3 million flee Venezuela
 Maternal mortality rate jumped 66%
 Maduro blames speculators and U.S.
 February, ‘19 Maduro’s troops block delivery of
emergency food and medicine from U.S.
 U.S. will cease dealing with Venezuela’s State oil
monopoly and put funds into an account for new
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democratic government (if happens)
Micro Supply and Demand
the model of competitive markets
 Demand shifts
∆ income, ∆ price of complements or substitutes,
∆ tastes, ∆ expectations of future prices or income
 Supply shifts
∆ input costs, ∆ price of a related good that uses
the same inputs, ∆ technology, ∆ business taxes or
subsidies, ∆ expectations about future prices
 Price ceilings and floors
 (Price ceilings in Venezuela, many goods
unavailable) 18
 The Simplest Macro Model
The Production Possibility Frontier

Clothing Food Opportunity Cost

0 60
2
10 58
6
20 52
12
30 40
15
40 25
25
50 0

 Note increasing opportunity cost

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 Summary of National Income
and Product Accounting — 1
GDP = C + I + G + X - IM

plus receipts of factor income from the rest of the world,

minus payments of factor income to the rest of the world

= GNP
less consumption of fixed capital (depreciation)

= NNP less statistical discrepancy = National Income

less indirect business taxes and any excess of
government enterprises’ receipts over their subsidies

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= National Income at Factor Cost
 Alternative means for determining
National Income at Factor Cost

National Income at Factor Cost is also equal to:

Compensation of Employees
+ Proprietors’ Income
+ Corporate Profits
+ Rental Income
+ Net Interest

21
 From National Income at Factor
Cost to Disposable Income
National Income at Factor Cost
Less contributions for Social Security
Less corporate profits plus dividends
Plus Transfers
Plus interest on the public debt

= Personal Income
Less personal income taxes

=Disposable Income

22
 Growth
 Theories of growth: neoclassical and endogenous

 China, as it embodies these theories

23
 Calculating
A=Total Factor Productivity
From the Cobb-Douglas Function: Y= A K L1 - 
Divide by L Then Y K 
L
=A( ) L
Y/L
or A =
( )K/L


24
Endogenous Growth Theory- Nine
Political/Social Reasons for Growth
I. An important cultural prerequisite to growth is whether
an innovator is a social deviant or a hero.
II. Degree of individual perspective (Individualism)
III. You need good property rights, including the protection of
intellectual property.
IV. Pro-business start-up state
and local rules

Early links to Stanford

University fostered Silicon
Valley entrepreneurialism 25
 Endogenous Growth Theory —2
V. There needs to be a cultural emphasis on education and the future

VI. Distribution of income:

a) If too uneven, can cause serious problems
b) forced equality can also cause serious problems

VII. Management/Labor relations

Mobility of Labor

VIII. Political Stability: pro-market

government
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 Endogenous Growth Theory — 3

IX. Open Economy

 Trade spreads information
 Technology spills over from
imports to domestic industry
 Allowing multinationals into your country
forces competition on domestic industry
 If concern that foreigners will destroy local culture leads to
protectionism, the result is lost growth opportunities
Port of Seattle
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 Special Features of China in ‘79,
On Eve of Transition
1) Rural Markets that had not been stamped out by communism;
helped agricultural reform under the responsibility system-(great
example of importance of politics and incentives)
2) No monetary overhang or external debt
3) Communist structure in China had been decentralized and local
governments and communes began acting like partnership businesses.
4) Hong Kong, Macao, and Taiwan were sources of investment and
management talent
5) Huge potential market brought foreign investment

28
China as an example of endogenous
and neoclassical growth
 Endo: TFP increased, Political change in 1978-9 changes
personal incentives of farmers. Responsibility system for
farming, 10 enterprise zones then markets spread to all of
China, Conversion to markets including local communes
operating businesses, local underlying culture comfortable
with innovation, cultural emphasis on education, opened to
international trade
 Change in incentives to save and invest as can profit causes
Investment over 30% of GDP in 1980s. Increased investment
means more capital inputs consistant with neoclassical
growth theory
 Labor input off of farm communes, had basic education,
^labor force participation 42 to 52% by mid 1990s
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Measures of Inflation
 Laspeyres uses basket of first period
 Paasche uses basket of later time period
 Paasche is smaller in inflationary periods
 Neither copes with new products that fall in
price. Chain linking helps
 Neither tells how to measure quality

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 Consequences of Inflation

I. Redistribution Effects
A. Redistribution if unanticipated inflation
a. lenders to borrowers
B. If the inflation is anticipated, then interest rates prevent these
redistributions mkt rate = real rate + inflationary expectation
If the inflation is anticipated, it is in the market interest rate.
the historical real rate = market rate - inflation
II. Deadweight loses : usury laws, distortion of information,
resources spent coping with inflation, uncertainty hurts I
example: Distortion of economic information as changes in
relative prices are distorted by inflation 31
Expectations and Consumption
 New inflationary expectations increase
consumption
 New deflationary expectations decrease
consumption

32
Three ways of looking at Equilibrium in the
Keynesian Cross Model
 (Assumes constant prices and interest rates)

Equilibrium is reached when:

1. Real planned expenditures (C + I + G + X - IM) equal real GDP
2. Planned saving equals planned investment
3. There are no unplanned inventory changes

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Forces toward equilibrium
 If planned expenditures> current production Y
Then planned saving < planned investment
Inventories are falling
=>increase output: hire people
 If planned expenditures< current production Y
Then planned saving >planned investment
There is unplanned inventory accumulation
=>cut output, fire people

34
 Demand side equilibrium
requires: Y = C + I + G +X-IM
C = Co +b YD
 YD = Y - T so C = Co +b (Y-T)
 T may = To+tY
 IM may = mY
 Keynesian Multiplier = 1/{1-b(1-t) + m}
 If put prices in, then Keynesian model doesn’t
have a unique solution. It gives AD,
i.e., a Y value for each price level
 C = Co +b YD + w W/P 35
 The Keynesian Model When Prices
Are Not Constant
C + I +G2 +X - IM
Planned With P= P1
Expenditure
C + I +G1 +X - IM
With P= P1

Y  If prices are not constant,

Price YE1 Keynesian model still gives
AS AD. But then we need AS to
P2 see where the new
equilibrium will go
P1
AD1 AD2
 Keynesian model is really
YE1 YE an AD model once Prices
Y are allowed to vary 36
 Demand-Management Counter-
Cyclical Fiscal Policy
 Increase G, increase Transfer Payments, or lower Taxes to
fight a recession
 Lower G, decrease Transfers, or raise taxes to close an

inflationary gap
 Note: activist fiscal policy need not necessarily mean bigger

Government
 One could fight a recession by decreasing taxes, and fight
inflation by decreasing G and transfer payments.

37
 What do variable prices do to the
actual multiplier?
1 Note: this Keynesian multiplier is
from the fixed-price model, so it
1-b (1-t) + m shows how far a stimulus moves
AD
 However, we need AS also to get the actual multiplication
Suppose the Keynesian multiplier is 2.5 and
P AD2 AS G increases by 200
AD moves right by 200 (2.5) = 500
AD1

But added demand drove up prices and that

reduced quantity demanded along AD2
Actual ∆Y= (true multiplier )∆G
500 700 1000 Y 200 = (1.0) 200 38
 A Recessionary Gap

potential GDP

Price AS
Level

Recessionary Gap

AD

YE Yfull 39
Y
A Recessionary Gap may self correct if wages and
prices fall without creating deflationary expectations

As wages fall, firms hire more

workers and produce more. AS
moves right and output prices fall
potential GDP

AS1
Price This is what
Level happened in the
AS2 US in 1920-21

AD

YE Yfull 40
Y
 Wages may be sticky and block
self correction
1. Workers fear relative loss in wages
2. Minimum wages and union contracts resist nominal wage
cuts.
3. Advantages to employers and employees of long-term
relationships: reducing uncertainty, search costs, training
costs.
4. Employers fear they will lose better workers
5. Efficiency wages (packet)
Also Employees might get angry and sabotage company
if wages are cut
41
 An Inflationary Gap
potential GDP
P
AS

Inflationary
Gap

AD

Yfull
42
Inflationary Gaps May Self Correct
Inflationary gaps may be eliminated by the process of rising
wages and prices.
1. Tight labor markets drive up nominal wages….AS shifts left
2. Higher prices reduce consumption and net exports

potential
GDP
AS2
P
AS1

AD
43
 Inflationary Gaps may not self
correct
WILL NOT SELF DESTRUCT IF:

1. New inflationary expectations increase

C at each price level….AD shifts rightward.
2. the source of the excessive AD continues
(e.g. the money supply, or excessive war spending)

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 Fighting an Inflationary Gap in a
Keynesian perspective
The inflationary gap can be closed by a decrease in Aggregate
Demand. AD can decrease from a decrease in consumption or
investment or exports or government spending

Government action would be to decrease G and/or decrease

Transfers, and/or raise taxes.

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