The Supply-Side ModelThe Supply-Side Modeland the New Economyand the New Economy

Chapter 10Chapter 10

By the early 1980s, Keynesian discretionary By the early 1980s, Keynesian discretionary demand-side stabilization policies were no demand-side stabilization policies were no longer effective.longer effective.

The output-inflation (Phillips curve) trade-off The output-inflation (Phillips curve) trade-off no longer in evidence.no longer in evidence.

Birth of the Birth of the Rational expectationsRational expectations School of School of macroeconomics. A new paradigm!macroeconomics. A new paradigm!

Hallmarks of this school of thought: Hallmarks of this school of thought: • Greater role of expectationGreater role of expectation• UncertaintyUncertainty• Asymmetric information. Asymmetric information.

This was helped by more advanced and This was helped by more advanced and sophisticated time-series analyses.sophisticated time-series analyses.

Crucial assumptionCrucial assumption: Information is : Information is asymmetric. By assumption, employers asymmetric. By assumption, employers know the changes in cotemporaneous know the changes in cotemporaneous prices and nominal wages but workers prices and nominal wages but workers do not know these changes in P and W do not know these changes in P and W in the current period.in the current period.

Causes of the so-called demise of Causes of the so-called demise of Keynesian macroeconomics: Keynesian macroeconomics:

Expectations-augmented AS curveExpectations-augmented AS curve

(Fig. 10.1)(Fig. 10.1)

1.1. Assume the economy is at PAssume the economy is at P00,Y,Y00 in the (P,Y) space and in the (P,Y) space and assume Passume P00 =2. =2.

2.2. As a result of a demand-side stabilization policy, ADAs a result of a demand-side stabilization policy, AD0 0 shifts shifts right to ADright to AD11. This causes P to increase to P. This causes P to increase to P11 (from 2 to 5), (from 2 to 5), and Wand W00 increases to W increases to W11 (from 12 to 15). (from 12 to 15).

3.3. Since information is asymmetric, employers know that Since information is asymmetric, employers know that prices have increased by more than 100% but workers prices have increased by more than 100% but workers see only the rise in their nominal wages (from 12 to 15).see only the rise in their nominal wages (from 12 to 15).

4.4. The asymmetry of information leads to more demand for The asymmetry of information leads to more demand for labor (since the real wage is lower) but workers think they labor (since the real wage is lower) but workers think they are better off and supply more labor.are better off and supply more labor.

5.5. As a result, employment increases to nAs a result, employment increases to n11..

6.6. As a result of n increasing, Y increases to YAs a result of n increasing, Y increases to Y11..

7.7. We link the points (PWe link the points (P11,Y,Y11) and (P) and (P00,Y,Y00) to obtain the ) to obtain the adaptive expectations AS curve (AE-AS)adaptive expectations AS curve (AE-AS). .

An Expectations-Augmented Explanation An Expectations-Augmented Explanation of the Paradigm Shiftof the Paradigm Shift

Do workers misinterpret observed changesDo workers misinterpret observed changes

in nominal wage as changes in real wage only in nominal wage as changes in real wage only

in the short and medium term?in the short and medium term?

(Fig. 10.2)(Fig. 10.2)

The last point covered in Fig 10.1 (point 7) is The last point covered in Fig 10.1 (point 7) is our starting point in Fig. 10.2. our starting point in Fig. 10.2.

We note that the positively sloped AE-AS We note that the positively sloped AE-AS curve facilitates the output-inflation tradeoffs.curve facilitates the output-inflation tradeoffs.

Eventually, workers catch on and realize that real Eventually, workers catch on and realize that real wages are going down. They then update their wages are going down. They then update their expectations and when another round of expectations and when another round of expansionary fiscal or monetary stabilization is expansionary fiscal or monetary stabilization is anticipated they indulge in pro-active long-term anticipated they indulge in pro-active long-term contracts (require that W=30 so that real wage contracts (require that W=30 so that real wage remains 6). Information has become symmetric! remains 6). Information has become symmetric! Employment equilibrium is back at nEmployment equilibrium is back at n0 0 ;; with Y = with Y = YY00 but P = but P = PP11..

We link the points (PWe link the points (P11,Y,Y00) and (P) and (P00,Y,Y00) to obtain the ) to obtain the rational expectations AS curve (RE-AS)rational expectations AS curve (RE-AS). Note . Note that the RE-AS curve is that the RE-AS curve is vertical!vertical! This is the This is the theoretical center piece of the new supply-side theoretical center piece of the new supply-side paradigm. paradigm.

The RE-AS is The RE-AS is also known as the new classical also known as the new classical AS curve.AS curve.

How can an economy move from the How can an economy move from the positively sloped AE-AS curve to the positively sloped AE-AS curve to the vertical RE-AS curve?vertical RE-AS curve?

Two requirements:Two requirements:

1.1. Sophisticated labor markets where market Sophisticated labor markets where market power can influence long-term labor power can influence long-term labor contracts.contracts.

2.2. Fully articulated and efficient bond markets.Fully articulated and efficient bond markets.

Shifting the AS curveShifting the AS curve According to this new paradigm, shifting According to this new paradigm, shifting

AD affects only the price level (P).AD affects only the price level (P). To increase GDP growth, the only viable To increase GDP growth, the only viable

option is to option is to shift the ASshift the AS to the right to the right ((supply-side modelsupply-side model).).

The main elements of supply-side The main elements of supply-side economics are:economics are:

1. Significant income/personal tax cuts.1. Significant income/personal tax cuts.

2. Extensive corporate/business tax cuts.2. Extensive corporate/business tax cuts.

3. Substantial deregulation 3. Substantial deregulation

Shifting the AS curveShifting the AS curveSignificant income/personal tax cutsSignificant income/personal tax cutsLabor Supply = f(real wage, personal tax rates, macro outlook)Labor Supply = f(real wage, personal tax rates, macro outlook)

(+) ((+) (-) (+)-) (+) Workers generally perceive tax cuts as temporary so they Workers generally perceive tax cuts as temporary so they

work More hours. Others see the incentive of joining the work More hours. Others see the incentive of joining the labor force. The labor supply curve shifts to the right. Tax labor force. The labor supply curve shifts to the right. Tax rate increases shift the labor supply curve to the left.rate increases shift the labor supply curve to the left.

Another explanation (Fig. 10.4): An increase in the tax Another explanation (Fig. 10.4): An increase in the tax rate (t) requires an increase in real wage (to keep rate (t) requires an increase in real wage (to keep employment at nemployment at n00) which results in an upward shift (left) in ) which results in an upward shift (left) in the labor supply curve (Fig, 10.4a).the labor supply curve (Fig, 10.4a).

In the rational expectations paradigm, taxes also influence In the rational expectations paradigm, taxes also influence the labor market (not just disposable income and the labor market (not just disposable income and consumption).consumption).

Shifting the AS curveShifting the AS curve Extensive corporate/business tax cutsExtensive corporate/business tax cuts Labor Demand = f(real wage, business tax rates, macro outlook)Labor Demand = f(real wage, business tax rates, macro outlook)

((--) () (-) (+)-) (+) Cuts in corporate/business taxes cause the labor Cuts in corporate/business taxes cause the labor

demand curve to shift to the right (Fig. 10.5).demand curve to shift to the right (Fig. 10.5).

DeregulationDeregulation Increases innovation and productivity (Fig. 10.6).Increases innovation and productivity (Fig. 10.6).

Supply-Side StabilizationSupply-Side Stabilization Incorporating the three major supply-side policiesIncorporating the three major supply-side policies (Fig. 10.7).(Fig. 10.7).1.1. We start from a low recessionary GDP growth rate We start from a low recessionary GDP growth rate

(Y(Y00) with RE-AS. Assume there is asymmetric ) with RE-AS. Assume there is asymmetric information.information.

2.2. Combining personal and business tax cuts with Combining personal and business tax cuts with substantial deregulation causes the RE-AS curve to substantial deregulation causes the RE-AS curve to shift to the right. shift to the right.

3.3. We have higher Y (higher production function), We have higher Y (higher production function), higher n (both supply and demand of labor shift to higher n (both supply and demand of labor shift to the right) and the right) and lower price levellower price level!!

A supply-side story: Ireland and IT.A supply-side story: Ireland and IT.

StagflationStagflation

Raising inflation and falling rates of employment Raising inflation and falling rates of employment

and GDP growth (Fig. 10.8and GDP growth (Fig. 10.8).).

The 1970s oil shocks and stagflation in the The 1970s oil shocks and stagflation in the U.S., Western Europe and Japan.U.S., Western Europe and Japan.

Late 2008: Rising prices and slowing growth.Late 2008: Rising prices and slowing growth.

The New EconomyThe New Economy Traces its roots to the supply-side policies implemented in Traces its roots to the supply-side policies implemented in

the early 1980s.the early 1980s. Deregulation fostered technological progress and led to an Deregulation fostered technological progress and led to an

upward shift in the production function.upward shift in the production function. Strong macroeconomic outlook caused labor demand and Strong macroeconomic outlook caused labor demand and

supply curves to shift to the right. So the equilibrium supply curves to shift to the right. So the equilibrium employment increased.employment increased.

The RE-AS curve shifted to the right.The RE-AS curve shifted to the right. Hallmark of the New Economy: GDP growth without higher Hallmark of the New Economy: GDP growth without higher

inflation.inflation. Mid 1990s-2000: U.S. average quarterly GDP growth rate was 5% Mid 1990s-2000: U.S. average quarterly GDP growth rate was 5%

and unemployment was in the 3% range, with no significant and unemployment was in the 3% range, with no significant increases in the rate of inflation.increases in the rate of inflation.

The New Economy and the productivity puzzle.The New Economy and the productivity puzzle.

The Identification ProblemThe Identification Problem(Fig. 10.9)(Fig. 10.9)

Oxford Dictionary of Economics definition:Oxford Dictionary of Economics definition: “The problem of estimating the parameters of structural “The problem of estimating the parameters of structural equations when all that can be observed is equilibrium equations when all that can be observed is equilibrium positions. For example, in the market for a particular good, positions. For example, in the market for a particular good, if demand conditions vary and supply conditions do not, if demand conditions vary and supply conditions do not, comparing prices and quantities at different times allows comparing prices and quantities at different times allows us to determine the supply equation. If supply conditions us to determine the supply equation. If supply conditions vary and demand conditions do not, we can estimate the vary and demand conditions do not, we can estimate the demand equation. But if both supply and demand demand equation. But if both supply and demand conditions vary, regressing quantity on price tells us conditions vary, regressing quantity on price tells us nothing. The identification problem can be resolved only if nothing. The identification problem can be resolved only if either theory or the results of other studies inform us that either theory or the results of other studies inform us that some explanatory variables affect one side of the market some explanatory variables affect one side of the market but not the other.” but not the other.”

A Keynesian Explanation of the A Keynesian Explanation of the New EconomyNew Economy

Keynesians argue that all AS curves (no matter Keynesians argue that all AS curves (no matter their shape) will shift to the right if the production their shape) will shift to the right if the production curve shifts upward as a result of higher labor curve shifts upward as a result of higher labor productivity.productivity.

Fig. 10.10a shows that even a Keynesian AS Fig. 10.10a shows that even a Keynesian AS curve shifts to the right as a result of higher curve shifts to the right as a result of higher productivity and will lead to the same results (New productivity and will lead to the same results (New Economy results, Fig. 10.10b).Economy results, Fig. 10.10b).

The New Economy Compared to The New Economy Compared to the ‘Old Economy’the ‘Old Economy’

The old or traditional economy: Keynesian AS.The old or traditional economy: Keynesian AS. The New economy: (vertical AS) supply sideThe New economy: (vertical AS) supply side

See Table 10.1See Table 10.1

Reconciling the Two ModelsReconciling the Two Models

In the developed economies: In the In the developed economies: In the long-run reconciliation will be highly long-run reconciliation will be highly unlikely.unlikely.

Possibility of a quasi-paradigm. A Possibility of a quasi-paradigm. A transition from the short-run AS curve transition from the short-run AS curve to a long-run supply-side model.to a long-run supply-side model.

This implies that in the short-run there is This implies that in the short-run there is room for demand-side stabilization room for demand-side stabilization policies.policies.

Robert Lucas and the ‘Islands’ Robert Lucas and the ‘Islands’ economyeconomy

The outlook for the New EconomyThe outlook for the New Economy

Which model can consistently explain Which model can consistently explain all macroeconomic behavior in the all macroeconomic behavior in the developed economy?developed economy?

Discussion: Article 10.2Discussion: Article 10.2