Question

(Related to the Apply the Concept on page 978 ) In 2017 , an article in the New York Times quoted Douglas HoltzEakin, former director of the Congressional Budget Office, as arguing that "with the economy back to near full employment, conventional tax cuts or stimulus spending won't have that much of an effect. What is needed are policies that genuinely augment the supply side of the economy." a. If the economy is at full employment, what economic variables will conventional tax cuts or stimulus spending not affect much? What variables might these policies affect? b. What does Holtz-Eakin mean by "policies that genuinely augment the supply side of the economy"?

Short answer

a. In full employment, conventional tax cuts or stimulus spending won't affect interest rates or inflation much, but may affect income distribution and wealth. b. By 'policies that genuinely augment the supply side of the economy', Holtz-Eakin likely means actions that improve the economy's capacity to produce, such as those that enhance technology, education, competition, or innovation, or reduce business regulatory barriers.

Step-by-step solution

Understanding Full Employment

Full employment refers to the scenario where all available labor resources are being utilized most effectively. It does not mean there is zero unemployment, but rather, only non-cyclical or structural types of unemployment exist.

Effect of Conventional Tax cuts or Stimulus Spending

In a situation of full employment, conventional tax cuts or stimulus spending (fiscal policy tools) would not affect nominal variables much like inflation or interest rates because there is no slack in the economy into which extra demand could be injected. The economy can't increase the quantity of output in the short term. However, these policies might impact real variables such as income distribution and wealth, depending on how they're implemented.

Interpreting Augmentation of Supply-side

Supply-side policies refer to actions that improve the capacity of an economy to produce. When Holtz-Eakin suggests policies that 'genuinely augment the supply side of the economy', he's likely referring to initiatives that increase productivity, enhance technology, improve education and training, encourage competition and innovation, or reduce regulatory barriers to business. These policies aim to shift the long-run aggregate supply curve to the right, expanding potential output and allowing for sustainable economic growth without leading to inflation.

Key concepts

Fiscal Policy

Fiscal policy involves government decisions about spending and taxation that can influence an economy. When the government pursues expansionary fiscal policy, it increases spending or decreases taxes to stimulate demand. In contrast, contractionary fiscal policy, achieved by decreasing government spending or increasing taxes, is meant to reduce demand.
In a state of full employment, the use of expansionary fiscal policy is less effective since there are fewer idle resources to mobilize. This is because, at full employment, additional demand can lead to inflationary pressure rather than an increase in output. The governmental tools, such as tax cuts, might, however, alter real variables by affecting disposable income and thus shifting consumption patterns or wealth distribution.

Supply-side Policies

Supply-side policies aim to increase the productive capacity of the economy and shift the long-run aggregate supply (LRAS) curve to the right. These policies focus on improving the efficiency and productivity of an economy. Examples include tax breaks for research and development, subsidies for education and training, deregulation, and policies to increase labor market flexibility.
By focusing on these areas, a government can enhance the overall production capabilities of its economic system. Such policies can lead to innovation, higher quality of goods and services, and increased competitiveness in international markets. In the context of the original exercise, these are the types of policies that could have a more lasting impact than conventional fiscal policy in an economy that is already at or near full employment.

Non-cyclical Unemployment

Non-cyclical unemployment refers to unemployment that is not related to the business cycle's ups and downs. This type of unemployment exists even when the economy is performing well. Causes are often structural, such as mismatches between workers' skills and job requirements or geographical mismatches between where jobs are and where people live.
To address non-cyclical unemployment, policies must be targeted at the root causes, which could include retraining programs, educational improvements, and relocation assistance. Since these forms of unemployment cannot be mitigated by stimulation of aggregate demand, they require interventions that directly influence labor market conditions and workers' abilities to secure employment.

Aggregate Supply

Aggregate supply (AS) represents the total output of goods and services that firms in an economy are willing to produce and sell at a given overall price level, over a certain time period. It is depicted as a curve on a graph showing price level on the vertical axis and output on the horizontal. In the short run, the AS is upward-sloping, reflecting that higher prices can coax more output from firms. In the long run, the AS is vertical, representing the economy's maximum sustainable output.
When supply-side policies improve factors such as productivity or technology, they shift the long-run aggregate supply (LRAS) curve to the right. This increase in potential output implies that more can be produced at every price level, allowing for growth without necessarily causing inflation – an essential consideration in an economy operating near full employment.