Supply-side policy — practice questions

(a) LRAS shift Draw LRAS₁ vertical at $600bn. Better skills and infrastructure → LRAS₂ to the right at e.g. $650bn.

(b) Long-run effects Yf rises to ~$650bn → economy can grow without hitting capacity constraints → non-inflationary growth possible. If AD adjusts gradually, P pressure eases (or rises more slowly). Structural unemployment falls as workers match new jobs.

(c) Comparison with $30bn G on subsidies Subsidy → AD shifts right immediately → at Yf, mainly P rises (demand-pull inflation) with limited sustainable Y gain.

Supply-side → capacity expands → growth without the same inflation trade-off, but benefits take years (time lag).

(a) Calculate the increase in capital stock (ΔK):

The policy leads to an additional net investment of $50 billion each year.

• Annual additional investment = $50 billion
• Duration = 4 years

Total increase in capital stock ($\Delta K$) is calculated as:

$\Delta K = \text{Annual Net Investment} \times \text{Number of Years}$ $\Delta K = \text{\textdollar}50 \text{ billion} \times 4 = \text{\textdollar}200 \text{ billion}$

The capital stock increases by $200 billion.

(b) Calculate the increase in potential output (ΔYf):

The incremental capital-output ratio (ICOR) of 4 means that $4 of new capital is required to generate $1 of additional annual output.

• ICOR = $\Delta K / \Delta Y_f = 4$

To find the increase in potential output ($\Delta Y_f$), we rearrange the formula:

$\Delta Y_f = \frac{\Delta K}{\text{ICOR}}$ $\Delta Y_f = \frac{\text{\textdollar}200 \text{ billion}}{4} = \text{\textdollar}50 \text{ billion}$

The economy's potential output increases by $50 billion per year.

(c) Reason for lower effectiveness:

The predicted increase in investment may not materialise. Firms might use the extra profits from the tax cut for other purposes, such as increasing dividend payments to shareholders or paying off debt, especially if business confidence is low. This means the link between tax cuts and investment is not automatic.