Lecture 5: Supply Side Policies PDF

Lecture 5 Supply side policies References : Hubbard and O'Brien Chapter 27 Mid term exam format Syllabus : Lecture 1 to lecture 4 Date and time : 4th November at 6:15 pm -7:15 pm (if you miss the mid term – it needs to be supported by a valid documentation) Venue : The Grand Hall Format :...

Lecture 5 Supply side policies References : Hubbard and O'Brien Chapter 27 Mid term exam format Syllabus : Lecture 1 to lecture 4 Date and time : 4th November at 6:15 pm -7:15 pm (if you miss the mid term – it needs to be supported by a valid documentation) Venue : The Grand Hall Format : 8 questions 4 Short answer questions ( no diagram) – 12 marks 2 Long answer questions (with diagram) – 10 marks 2 Numerical questions – 8 marks DR.DEBOSHREE GHOSH 2 Learning outcomes of today’s lecture Supply – side fiscal policy : government expenditure. Example of wage subsidy supply side policy Discretionary vs non discretionary fiscal policy DR.DEBOSHREE GHOSH 3 Story till now.. Fiscal policy affects aggregate demand. Expansionary fiscal policy is for recessionary periods Contractionary fiscal policy is for inflationary periods But what about aggregate supply?? DR.DEBOSHREE GHOSH 4 Discretionary and non-discretionary fiscal policy Fiscal policy could also be discretionary or automatic (nondiscretionary) Discretionary fiscal policy is a policy action that is explicitly initiated by the federal government – involves deliberate government intervention. Automatic (non-discretionary) fiscal policy refers to strategy (policies already in place) to counter fluctuations in the business cycle without need for deliberate government intervention. DR.DEBOSHREE GHOSH 5 Non-discretionary fiscal policy Suppose the government does not intervene then how does economy stabilise in case of recession or inflation? Automatic stabilizers : components of fiscal policy already in the economic system that automatically  fluctuations/shocks in AD. Example of automatic stabilizers : Existing tax system, welfare benefits i.e. transfer payments) DR.DEBOSHREE GHOSH 6 Non-discretionary fiscal policy Example of mechanism : In a recession, unemployment rises and income falls. People now have access to transfer payments (TR). An increase in transfer payments would lead to an increase in aggregate demand (AD) since consumption increases. In a period of inflation, employment rises and income increases. Higher income means that people pay more in taxes, leading to a decrease in aggregate demand (AD) since disposable income decreases hence consumption decreases DR.DEBOSHREE GHOSH 7 Elaborating on factors affecting : Long Run Aggregate Supply (LRAS) Short run Run Aggregate Supply (SRAS) 1. Human capital (increasing in skill base or a permanent increase in number of workers) 1. When LRAS shifts since long term projected changes have impact on short term production decisions and productivity. a) Technology impacting productivity b) Skills c) Capital 2. Technological advancement 3. Increase in capital (machinery) 4. Changes in resources and institutional factors which lead to permanent changes in the economy 2. Factors which impact input prices 3. Short run supply shocks Short-run aggregate supply is influenced by factors affecting production costs and expectations in the near term, long-run aggregate supply is determined by structural factors that impact an economy's productive capacity over time, such as technological progress, labour force growth, and institutional frameworks. DR.DEBOSHREE GHOSH 8 Supply side policies Supply-side policies can include both fiscal and non-fiscal measures. They are aimed to increase potential output and long run aggregate supply for long run economic growth Fiscal supply-side policies involve tax cuts, targeted subsidies, or investment in infrastructure and education. Non-fiscal policies include measures such as deregulation, labour market reforms, privatization, and trade liberalization. Supply side measures can be further catgeorised into free market and interventionist supply side policies DR.DEBOSHREE GHOSH 9 Types of supply side policies Interventionist supply-side policies refer to a set of economic strategies and interventions implemented by governments to directly influence and improve the productivity, efficiency, and performance of markets and industries within an economy. Interventionist supply-side policies involve active government involvement in shaping economic outcomes. Free-market supply-side policies are economic strategies that prioritize minimal government intervention and rely on market forces to drive productivity, efficiency, and growth within an economy. Free-market supply-side policies emphasize the importance of allowing businesses and individuals to operate with minimal regulatory constraints and interference. DR.DEBOSHREE GHOSH 10 Types of supply side policies These policies can be fiscal or non-fiscal DR.DEBOSHREE GHOSH 11 Fiscal Policy – Expansionary fiscal policy - Effect on SAS Price level (GDP Deflator) At point A there is a recessionary gap i.e. potential GDP > actual GDP (see lecture 3) Recessionary gap implies that there is lower equilibrium real GDP than expected therefore lower number of jobs as well. The correction strategy is to apply expansionary fiscal policy. 100 However, the question remains should apply policies which expand (increase aggregate demand or aggregate supply) LAS SAS0 A AD0 400 410 Real GDP ($ billions) DR.DEBOSHREE GHOSH 12 Fiscal Policy – Expansionary fiscal policy - Effect on SAS Price level (GDP Deflator) Assume the government decides to take the aggregate supply path. Example, the government announces a reduction in corporate taxes. This pushes out SAS since lower corporate taxes would make cost of production cheaper and SAS moves out and price of products drop. When the supply curve shifts out, the aggregate supply in the economy reaches point B at the same price level of 100. 100 90 The level of AD is still at point A therefore there will be excess supply situation. This causes the price level to decrease from 100 to 90. DR.DEBOSHREE LAS SAS0 SAS1 B A C AD0 400 410 Real GDP ($ billions) GHOSH 13 Fiscal Policy – Expansionary fiscal policy - Effect on SAS Price level (GDP Deflator) There is a movement along the AS curve from point B to point C because of sticky wage theory. 𝑚𝑜𝑛𝑒𝑦 𝑤𝑎𝑔𝑒 r𝑒𝑎𝑙 𝑤𝑎𝑔𝑒 = 𝑃𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 Since and when prices decrease from 100 to 90 due to excess supply, therefore real wages start increasing (denominator becomes smaller) and suppliers hire lesser workers since it is costlier to hire them at higher real wages. 100 90 Movement along the AD curve from point A to point C happens because of wealth and substitution effect (see lecture 3) DR.DEBOSHREE LAS SAS0 SAS1 B A C AD0 400 410 Real GDP ($ billions) GHOSH 14 Fiscal Policy – Contractionary fiscal policy - Effect on SAS Price level (GDP Deflator) At point A there is an inflationary gap i.e. potential GDP < actual GDP (see lecture 3) During inflationary gap, assume that the contractionary fiscal policy implemented affects the SAS for example increasing corporate taxes. The taxes would make cost of production higher and SAS shifts in since not all producers can afford a higher cost of production. 110 100 LAS SAS1 SAS0 C B A At the same price level of 100, there will be shortage of supply causing the price level to increase from 100 to 110. Real GDP and price level is now at long run (potential GDP) level (point C) DR.DEBOSHREE AD0 400 410 GHOSH Real GDP ($ billions) 15 Fiscal Policy – Contractionary fiscal policy Price level (GDP Deflator) - Effect on SAS There is a movement along the AS curve from point B to point C because of sticky wage theory. 𝑚𝑜𝑛𝑒𝑦 𝑤𝑎𝑔𝑒 Since r𝑒𝑎𝑙 𝑤𝑎𝑔𝑒 = and prices 𝑃𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 increase from 100 to 110 due to shortage of supply, therefore real wages start decreasing and suppliers hire more workers since it is cheaper to hire them at lower real wages. Movement along the AD curve from point A to point C happens because of wealth and substitution effect (see lecture 3) DR.DEBOSHREE 110 100 SAS1 SAS0 LAS C B A AD0 400 410 GHOSH Real GDP ($ billions) 16 Fiscal Policy – Expansionary fiscal policy Price level (GDP Deflator) - Effect on LAS LAS0 LAS1 SAS0 100 A Suppose we are at long run equilibrium A Now due to increase in human capital, physical capital or technology factors, LAS0 moves out to LAS1. This can happen if government assists through policies such as investment in skill development, AI etc. Since LAS has moved out, SAS0 also moves out to SAS1. Long run equilibrium is achieved when AD0 = LAS1= SAS1 B AD0 Output is higher and price is lower DR.DEBOSHREE SAS1 400 410 GHOSH Real GDP ($ billions) 17 Fiscal Policy – Expansionary fiscal policy Price level (GDP Deflator) - Effect on AD after LAS and SAS move LAS0 LAS1 SAS0 100 A Depending on the policy, AD MIGHT shift out too (if there is G change) The equilibrium real GDP will increase further from 410 but the price level might increase , decrease or remain the same (compare point A and point C) depending on how much SAS and AD curves have shifted out C B AD1 In this diagram, shift in AD=shift in AS. Price remains the same DR.DEBOSHREE SAS1 AD0 400 410 GHOSH Real GDP ($ billions) 18 Fiscal Policy – Expansionary fiscal policy Price level (GDP Deflator) - Effect on AD after LAS and SAS move Example of when AD shifted out due to increase in consumption and investment spending, and the price level increases as AD increased much more than shift in SAS LAS0 LAS1 SAS0 SAS1 C 100 A B AD1 AD0 400 410 DR.DEBOSHREE GHOSH 19 Fiscal Policy – Expansionary fiscal policy Price level (GDP Deflator) - Effect on AD after LAS and SAS move LAS0 LAS1 SAS0 100 A Example of when AD shifted out due to increase in consumption and investment spending, and the price level decreases as AD increased less than shift in SAS In any case, the equilibrium achieved after an outward shift of the AD curve is only short-term because LAS = AD = AS is not achieved. As a result, the SAS and AD curves keep adjusting until the point where LAS = AD = AS is reached. DR.DEBOSHREE B SAS1 C AD AD0 1 400 410 GHOSH 20 The choice between supply side and demand side fiscal policies Expansionary fiscal policy (assuming recessionary gap) G, T ,  TR Contractionary fiscal policy (assuming inflationary gap) G, T ,  TR Aggregate demand Example : Reduce personal income tax Effect : Real GDP (output) : Increase Employment : Increase Price level : Increase Example: Increase personal income tax Effect : Real GDP (output) : Decrease Employment : Decrease Price level : Decrease Short Run aggregate supply Example : Wage subsidy Effect : Real GDP (output) : Increase Employment :Increase Price level : Decrease Example : Increase corporate tax Effect : Real GDP (output) : Decrease Employment : Decrease Price level : Increase SHIFT IN DR.DEBOSHREE GHOSH 21 Budget 2025 – where do we stand? Let’s consider some announced policy examples which were recently announced Removal of RON 95 subsidy for the top T15 Additional tax for fee-based transactions Minimum wage increase from RM 1500 to RM 1700 DR.DEBOSHREE GHOSH 22 Removal of RON 95 Subsidy for the Top T15 Impact: As fuel is a critical input, higher fuel costs can raise production costs, especially for businesses dependent on logistics. The disposable income of high-income earners (T15) will decline, reducing their consumption. Curve Shift: Short-Run Aggregate Supply (SRAS): Shifts left due to increased production costs, resulting in reduced output at each price level. Aggregate Demand (AD): Might decrease slightly if reduced spending by T15 outweighs any government savings or redistribution efforts. However, the T15 may have a smaller marginal propensity to consume, limiting the AD shift. DR.DEBOSHREE GHOSH 23 Additional tax for fee-based transactions Impact: This will increase transaction costs, discouraging spending on services with fees (e.g., banking, online transactions). Reduced spending on these services may cause a decline in both consumer and business consumption. Curve Shift: Aggregate Demand (AD): Shifts left because higher transaction costs reduce consumption and business investment. (Maybe if the suppliers are able to shift the tax to the consumers) Short-Run Aggregate Supply (SRAS): No significant shift, unless the tax raises administrative costs for firms, which could marginally increase production costs. DR.DEBOSHREE GHOSH 24 Minimum wage increase from RM 1500 to RM 1700 Impact: Higher wages will increase workers’ income, which may boost consumption, shifting AD to the right. However, higher labor costs might also reduce profits and production capacity in the short run, leading to a reduction in SRAS. Curve Shift: Aggregate Demand (AD): Shifts right as workers spend more due to increased wages. Short-Run Aggregate Supply (SRAS): Shifts left due to higher labor costs. DR.DEBOSHREE GHOSH 25 The wage subsidy is a financial assistance paid to employers of every enterprise During recession or an economic downturn, wage subsidy helps by : 1. Prevents layoffs 2. Encourages hiring 3. Sustains consumer spending DR.DEBOSHREE GHOSH 26 Supply side policy example – wage subsidy Suppose we are point A (lower than full employmenthence recession) Supply side policy in this case would be used push the SAS curve out through fiscal policy such as introducing a wage subsidy. A wage subsidy would make cost of production cheaper and SAS moves out and price of products drop. Movement along the AD curve (from a to c) happens due to wealth and substitution effect. Movement along the AS curve (b to c) happens due to sticky wage theory At new equilibrium c , the output (real GDP) has increased and prices have dropped. DR.DEBOSHREE GHOSH 27 Summary Fiscal policy can affect both aggregate demand and aggregate supply Impact on LAS due to fiscal policy would affect SAS and AD. The final impact on price would depend on how much SAS and AD have shifted. Supply side policies can be both fiscal and non fiscal Supply side policies can be further categorized according to free market and interventionist policy An economy can be stabilized using existing nondiscretionary policies. DR.DEBOSHREE GHOSH 28 Next Week Guest lecture on inflation and unemployment DR.DEBOSHREE GHOSH 29