5 Steps to a 5 AP Macroeconomics 2019

136 ❯ Step 4. Review the Knowledge You Need to Score High

“Productivity-friendly” policies should make it easier to invest, easier to save, or both. Some

economists believe that supply-side policies have the potential to increase productivity, and

therefore economic growth.

Supply-Side Policies

So far the discussion of fiscal policy is centered on changing government spending and/or

taxing to expand or contract AD as a way to move the economy closer to full employment.

Other economists believe that the government’s fiscal policy should not be so proactive

in manipulation of AD. These economists advocate a government that is more hands-

off when it comes to fiscal policy. These economists believe that the economy generally

moves to full employment without government intervention, but if the government does

get involved, fiscal policy should focus on, or at least strongly consider, the AS half of the

equation by providing incentives to increase saving and investment. The main idea behind

supply-side fiscal policy is that tax reductions targeted to AS increase AS so that real GDP

increases with very little inflation. This was our “best of all possible macroeconomic situa-

tions” from the previous chapter.

Saving and Investment

Supply-side proponents would suggest policies that lower, or remove, taxes on income

earned from savings. This would encourage saving and increase the supply of loanable funds,

decrease the real interest rate, and increase the amount of money that firms invest. Figure 10.9

shows an increase in the supply of loanable funds. These economists would also propose an

investment tax credit, which reduces a firm’s taxes if it invests in physical capital.

Interest Rate

Loanable Funds ($)

S 0

D

i %

$F

S 1

Figure 10.9

Lower income taxes increase disposable income for households, increase both con-

sumption and savings from households, and increase the profitability of investment

for firms. This increase in saving and investment allows for an increase in the productive

capacity of a nation because more capital stock is accumulated. Ideally, this increase in

investment increases the long-run AS curve. The increase in long-run AS is illustrated in

Figure 10.10. Tax incentives to increase saving and investment on the supply side are likely

to also increase AD. (Note: The price level is shown to remain constant, but this does not

have to be, depending upon the magnitudes of the two curves’ shifts.)