The Supply-Side Model and the New Economy

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The Supply-Side Modeland the New Economy

• Chapter 10

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• By the early 1980s, Keynesian discretionary
  demand-side stabilization policies were no longer
  effective.
• The output-inflation (Phillips curve) trade-off
  no longer in evidence.
• Birth of the Rational expectations School of
  macroeconomics. A new paradigm!
• Hallmarks of this school of thought
• Greater role of expectation
• Uncertainty
• Asymmetric information.
• This was helped by more advanced and
  sophisticated time-series analyses.

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Causes of the so-called demise of Keynesian
macroeconomics Expectations-augmented AS curve

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

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• (Fig. 10.1)
• Assume the economy is at P0,Y0 in the (P,Y)
  space and assume P0 2.
• As a result of a demand-side stabilization
  policy, AD0 shifts right to AD1. This causes P to
  increase to P1 (from 2 to 5), and W0 increases
  to W1 (from 12 to 15).
• Since information is asymmetric, employers know
  that prices have increased by more than 100 but
  workers see only the rise in their nominal wages
  (from 12 to 15).
• The asymmetry of information leads to more demand
  for labor (since the real wage is lower) but
  workers think they are better off and supply more
  labor.
• As a result, employment increases to n1.
• As a result of n increasing, Y increases to Y1.
• We link the points (P1,Y1) and (P0,Y0) to obtain
  the adaptive expectations AS curve (AE-AS).

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An Expectations-Augmented Explanation of the
Paradigm Shift

• Do workers misinterpret observed changes
• in nominal wage as changes in real wage only
• in the short and medium term?
• (Fig. 10.2)
• The last point covered in Fig 10.1 (point 7)
  is our starting point in Fig. 10.2.
• We note that the positively sloped AE-AS
  curve facilitates the output-inflation tradeoffs.

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• Eventually, workers catch on and realize that
  real wages are going down. They then update their
  expectations and when another round of
  expansionary fiscal or monetary stabilization is
  anticipated they indulge in pro-active long-term
  contracts (require that W30 so that real wage
  remains 6). Information has become symmetric!
  Employment equilibrium is back at n0 with Y
  Y0 but P P1.
• We link the points (P1,Y0) and (P0,Y0) to obtain
  the rational expectations AS curve (RE-AS). Note
  that the RE-AS curve is vertical! This is the
  theoretical center piece of the new supply-side
  paradigm.
• The RE-AS is also known as the new classical AS
  curve.

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

• Two requirements
• Sophisticated labor markets where market power
  can influence long-term labor contracts.
• Fully articulated and efficient bond markets.

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Shifting the AS curve

• According to this new paradigm, shifting AD
  affects only the price level (P).
• To increase GDP growth, the only viable option is
  to shift the AS to the right (supply-side model).
• The main elements of supply-side economics are
• 1. Significant income/personal tax cuts.
• 2. Extensive corporate/business tax cuts.
• 3. Substantial deregulation

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Shifting the AS curve

• Significant income/personal tax cuts
• Labor Supply f(real wage, personal tax rates,
  macro outlook)
• () (-)
  ()
• Workers generally perceive tax cuts as temporary
  so they work More hours. Others see the incentive
  of joining the labor force. The labor supply
  curve shifts to the right. Tax rate increases
  shift the labor supply curve to the left.
• Another explanation (Fig. 10.4) An increase in
  the tax rate (t) requires an increase in real
  wage (to keep employment at n0) which results in
  an upward shift (left) in the labor supply curve
  (Fig, 10.4a).
• In the rational expectations paradigm, taxes also
  influence the labor market (not just disposable
  income and consumption).

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Shifting the AS curve

• Extensive corporate/business tax cuts
• Labor Demand f(real wage, business tax rates,
  macro outlook)
• (-)
  (-) ()
• Cuts in corporate/business taxes cause the labor
  demand curve to shift to the right (Fig. 10.5).
• Deregulation
• Increases innovation and productivity (Fig.
  10.6).

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Supply-Side Stabilization

• Incorporating the three major supply-side
  policies
• (Fig. 10.7).
• We start from a low recessionary GDP growth rate
  (Y0) with RE-AS. Assume there is asymmetric
  information.
• Combining personal and business tax cuts with
  substantial deregulation causes the RE-AS curve
  to shift to the right.
• We have higher Y (higher production function),
  higher n (both supply and demand of labor shift
  to the right) and lower price level!
• A supply-side story Ireland and IT.

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Stagflation

• Raising inflation and falling rates of
  employment
• and GDP growth (Fig. 10.8).
• The 1970s oil shocks and stagflation in the U.S.,
  Western Europe and Japan.
• Late 2008 Rising prices and slowing growth.

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The New Economy

• Traces its roots to the supply-side policies
  implemented in the early 1980s.
• Deregulation fostered technological progress and
  led to an upward shift in the production
  function.
• Strong macroeconomic outlook caused labor demand
  and supply curves to shift to the right. So the
  equilibrium employment increased.
• The RE-AS curve shifted to the right.
• Hallmark of the New Economy GDP growth without
  higher inflation.
• Mid 1990s-2000 U.S. average quarterly GDP growth
  rate was 5 and unemployment was in the 3 range,
  with no significant increases in the rate of
  inflation.
• The New Economy and the productivity puzzle.

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The Identification Problem(Fig. 10.9)

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

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A Keynesian Explanation of the New Economy

• Keynesians argue that all AS curves (no matter
  their shape) will shift to the right if the
  production curve shifts upward as a result of
  higher labor productivity.
• Fig. 10.10a shows that even a Keynesian AS curve
  shifts to the right as a result of higher
  productivity and will lead to the same results
  (New Economy results, Fig. 10.10b).

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The New Economy Compared to the Old Economy

• The old or traditional economy Keynesian AS.
• The New economy (vertical AS) supply side
• See Table 10.1

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Reconciling the Two Models

• In the developed economies In the long-run
  reconciliation will be highly unlikely.
• Possibility of a quasi-paradigm. A transition
  from the short-run AS curve to a long-run
  supply-side model.
• This implies that in the short-run there is room
  for demand-side stabilization policies.
• Robert Lucas and the Islands economy

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• The outlook for the New Economy
• Which model can consistently explain all
  macroeconomic behavior in the developed economy?
• Discussion Article 10.2