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) Definition The capital-output ratio measures the amount of capital needed to produce one unit of output. A ratio of 3:1 means $3 of capital stock is required to generate $1 of national output.

(b) Calculation Step 1: Calculate the increase in investment. The increase in annual net investment is the new level minus the old level. $\Delta K = \text{\textdollar}65 \text{ billion} - \text{\textdollar}50 \text{ billion} = \text{\textdollar}15 \text{ billion}$ This represents the annual addition to the nation's capital stock.

Step 2: Apply the capital-output ratio. The change in potential output ($\Delta Y_f$) is the change in capital stock ($\Delta K$) divided by the capital-output ratio. $\Delta Y_f = \frac{\Delta K}{\text{Capital-Output Ratio}}$

Step 3: Calculate the final value. $\Delta Y_f = \frac{\text{\textdollar}15 \text{ billion}}{3} = \text{\textdollar}5 \text{ billion}$

Conclusion: The supply-side policy is estimated to increase the economy's potential output by $5 billion per year. Note that this effect relies on firms actually increasing investment and is subject to time lags.