Solutions to Review Week 11 Supply-side models of inflation

Are the following statements true or false? Explain your answers in detail.

1. The monetarist cure for inflation involves a form of money rule that will ultimately squeeze
inflationary expectations out of the system.

True.
The money rule in a generic sense produces either decline in the absolute domestic money
supply as measured by either Mo or M1 or M3 or Broad Money but especially in terms of Mo or a
decline in the growth rate of Real GDP when compared to the domestic interest rate. In relation to
the latter this means that annual growth rate in nominal GDP is less than the annual growth rate in
the domestic inflation rate. Under either approach real money supply falls and so domestic interest
rates will increase. In turn both domestic planned investment expenditure will decrease and secondly
consumption expenditure on consumer durables that tend to be highly interest-rate sensitive will
decrease. Therefore in terms of the standard Accelerationist or Adaptive-Expectations Phillips Curve
diagram, the economy will be operating to the right-hand side of the LRAS (or the LOCE).
Therefore unemployment will increase as long as Pe is > Pa. Therefore W/Pe is < than W/Pa. Given
increasing levels of cyclical unemployment operating in domestic labour markets, it is likely that
workers/employees will be prepared to accept wage reductions rather than face extended periods of
unemployment. OK. As Pa falls in turn Pe will fall.

2. Supply side shocks are uncommon, and anyway they do not affect the position of either the
SRAS or the SRPC.

False.
There are numerous types of supply-side shocks both negative and positive and they will
affect the location of both the SRAS and in turn the SRPC. These include:

Real Wage explosions

OPEC and other induced increases in power, fuel and energy prices
Deteriorating Terms of Trade as Imports prices increase whilst Export prices
decrease
Depreciation of the domestic currency
Raw material shortages
Crop and agricultural commodity shortages
Falling productivity levels

On the other positive supply-side shocks include:

Technology changes that lead to increases in productivity such as the reduction in
the cost of personal computing over the last decade
The introduction of new and cheaper substitutes for an expensive production input
such as, the discovery of a seam of low-sulphur coal deposits to replace existing coal
inputs..

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All of these factors will lead to a shift in either the SRAS and/or the SRPC. Any increase in costs
will shift the SRAS upwards to the left whilst any decrease in costs will shift the SRAS downwards
to the right.

Alternatively, if these factors lead to an increase in the costs of production then the relevant SRPC
will shift vertically up along the LRAS/LRPC as cost conditions increase. The reverse will apply
when production costs fall due to ant of these factors.

3. Market power and monetary accommodation are necessary ingredients in acceptable

supply side models of inflation and stagflation.

True. Any acceptable and relevant model of supply-side inflation must incorporate a
recognition of market power imbalances on both the employer and the employee sides.
When such a model is being constructed certain assumptions are made. In this case it is
assumed that in the associated labour market, that unions, and so employees, have excessive
market power in terms of securing excessive money wages. Alternatively, we could make
assumptions that firms or companies have excessive market power in relation to prices.

Furthermore there are 3 clear steps that must included when a model of supply-side inflation
is composed. These are:
1. Money wage rates increase above expectations
2. As money wage rates increase, prices then increase
3. As prices increase, domestic nominal money supply increases.

In order to finalise a comprehensive model of supply-side inflation, there must be rational

explanation as to why central banks (and/or monetary authorities) allow the domestic
nominal money supply to increase at the same rate as the actual inflation rate. In your notes
3 uite clear pressures are identified that explain the latter. These are:

1. SOCIAL PRESSURES
2. ECONOMIC PRESSURES
3. POLITICAL/ELECTORAL PRESSURES

4. Governments should stimulate the economy in the face of a supply shock.

False. Governments have the OPTION to consider using a range of Demand-Management

policies to deal with a Supply-Side shock. These include:

A NEUTRAL POLICY
AN EXTINGUISHING POLICY
AN ACCOMODATING POLICY

Each of these are shown on the Topic 11PowerPoint Overheads.

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The policy results for the latter have been mixed. Often there have only neen marginal benfits at best
whilst there have been quite significant costs. They include:

- Loss of market

- Resource misallocation (labour, goods)

- Micro inefficiencies underpin pent up pressures

- Promotes rigidities / inefficiencies

- Ad hoc redistribution of income

- Industrial relations problems

5. Supply side policies, despite their name, are of no use in combating supply side inflation.

False. Whilst supply-side policies have shown to have produced mixed results when applied
during the 1980s and early 1990s in the UK and US, respectively, from a theoretical
perspective they do have some credibility. Historically the key focus has been on the effect of
marginal tax rates upon the level of economic activity. The latter varible is crucial because it affects
the incentive to earn. The marginal tax rate reveals how much of ones additional income must be
turned over to the taxation department as well as how much is retained by the individual. For
example, when the marginal rate is 40 percent, forty of every one hundred dollars of additional
earnings must be paid in taxes, and the individual is permitted to keep only sixty dollars of his or her
additional income. As marginal tax rates increase, people get to keep less of what they earn.

An increase in marginal tax rates can adversely affects the output of an economy in two ways. First,
the higher marginal rates reduce the payoff people derive from work and from other taxable
productive activities. When people are prohibited from obtaining or keeping much of what they
earn, they will perhaps earn more sparingly. Thus, when marginal tax rates rise, some peoplethose
with working spouses, for example will opt out of the labour force. Others will decide to take
more vacation time, retire earlier, or give up overtime opportunities. Still others will decide to give
up promising but risky business opportunities. In some cases, high tax rates will even drive highly
productive citizens to other countries where taxes are lower. These adjustments and others like
them will shrink the effective supply of resources, and therefore will shrink output.

Secondly, high marginal tax rates encourage tax-shelter investments and other forms of tax
avoidance. This is inefficient. If, for example, a one-dollar item is tax deductible and the individual
has a marginal tax of 40 percent, he will buy the item if it is worth more than sixty cents to him
because the true cost to him is only sixty cents. Yet the one-dollar price reflects the value of
resources given up to produce the item. High marginal tax rates, therefore, cause an item with
a cost of one dollar to be used by someone who values it less than one dollar. Taxpayers facing high
marginal tax rates will spend on pleasurable, tax-deductible items such as plush offices,
professional conferences held in favourite vacation spots, and various fringe benefits (e.g., a
company luxury automobile, business entertainment, and a company retirement plan). Real

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output is less than its potential because resources are wasted producing goods that are valued less
than their cost of production.

Recent research by economists such as Edwanrd Prescott have shown that marginal tax rates
tend to have a much greater effect upon the supply of labour in the long run as opposed to the short-
run. Therefore measures such as labour elasticity of supply were shown to be much more sensitive
in the longer time period than in the shorter time period. This would suggest that marginal tax rates
can make a difference. In terms of supply-side factors. However the debate goes on between
Keynesian and non-Keynesian economists in relation to this issue.

6. Monetarists and Keynesians can in general be said to be in conflict concerning the

benefits of prices and incomes policies.

True. However as we do not cover this topic any more in this course, it can be ignored.