This module discusses two of the most important supply shocks: productivity growth and changes in input prices. In the long run, the most important factor shifting the AS curve is productivity growth. Productivity means how much output can be produced with a given quantity of inputs. One measure of this is output per worker or GDP per capita. Over time, productivity grows so that the same quantity of labor can produce more output.
A higher level of productivity shifts the AS curve to the right, because with improved productivity, firms can produce a greater quantity of output at every price level. The interactive below Figure 1 shows an outward shift in productivity over two time periods. A shift in the SRAS curve to the right will result in a greater real GDP and downward pressure on the price level, if aggregate demand remains unchanged.
However, productivity grows slowly, at best only a few percentage points per year. As a consequence, the resulting shift in SRAS, increase in Q and decrease in P will be relatively small over a few months or even a couple of years. Higher prices for inputs that are widely used across the entire economy, such as labor or energy, can have a macroeconomic impact on aggregate supply.
Increases in the price of such inputs represent a negative supply shock, shifting the SRAS curve to shift to the left. This means that at each given price level for outputs, a higher price for inputs will discourage production because it will reduce the possibilities for earning profits. The movement from the original equilibrium of E 0 to the new equilibrium of E 1 will bring a nasty set of effects: reduced GDP or recession, higher unemployment because the economy is now further away from potential GDP, and an inflationary higher price level as well.
For example, the U. In the s, this pattern of a shift to the left in AS leading to a stagnant economy with high unemployment and inflation was nicknamed stagflation. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear.
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The Ford Administration conducted an expansionary fiscal policy, driven largely by tax cuts, which you would expect from a Republican and thus neoclassical administration. Watch the clip from this video to better understand what happened with stagflation during the s economic crisis, as well as the policies taken by the Fed to put an end to rising inflation.
Neoclas sical economists believe that the economy will rebound out of a recession or eventually contract during an expansion because prices and wage rates are flexible and will adjust either upward or downward to restore the economy to its potential GDP. Thus, the key policy question for neoclassicals is how to promote growth of potential GDP. We know that economic growth ultimately depends on the growth rate of long-term productivity. Productivity measures how effective inputs are at producing outputs.
We know that U. We also know that productivity growth varies a great deal in the short term due to cyclical factors. It also varies somewhat in the long term. From —, U. From —, productivity growth declined significantly to 1. Promotion of these factors is what government policy should focus on. Keynesian economists also support policies to promote economic growth, but not to the exclusion of countercyclical policies—those that try to diminish the fluctuations of business cycles.
Most Republican administrations favor tax cuts to promote economic growth. We saw this with the Ford administration, but it was also a large motivation for the Reagan tax cuts.
Democratic administrations are more likely to support increases in government spending on education and infrastructure investment.
The economic boom of the s was driven by private investment as the Internet became increasingly available. While the Clinton Administration failed to achieve its health care reform goals, it did manage to boost the Head Start program, which provides preschool for low income children. Fiscal policy was also moderately contractionary as budget deficits became budget surpluses, in part as an attempt to reduce the likelihood of crowding out which would limit private investment and future economic growth.
Neoclassicals prefer to focus policy on economic growth. They think that economic growth is fostered by a stable economic environment with a low rate of inflation. Similarly, tax rates should be low and unchanging. In this environment, private economic agents can make the best possible investment decisions, which will lead to optimal investment in physical and human capital as well as research and development to promote improvements in technology.
Keynesians also believe in promoting economic growth, but they favor government investment in infrastructure, a form of government spending, as well as both direct spending and tax cuts to promote research and development, and spending on human capital, that is education, both K12 and higher education.
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