Download IB Economics Section 2.6 Supply

IB ECONOMICS
SECTION 2.6 SUPPLY-SIDE POLICIES
23.Explain that supply-side policies aim at positively affecting the production side of an
economy by improving the institutional framework and the capacity to produce (that is, by
changing the quantity and/or quality of factors of production).
Supply-side economic policies are mainly microeconomic policies designed to improve the supply-side
potential of an economy, make markets and industries
operate more efficiently and thereby contribute to a
faster rate of growth of real national output
The “supply side” refers to factors affecting the quantity or
quality of goods and services produced by an economy
such as the level of productivity or investment in research
and development.
23.Explain that supply-side policies aim at positively affecting the production side of an
economy by improving the institutional framework and the capacity to produce (that is,
by changing the quantity and/or quality of factors of production).
Supply-side policies in fact aim for the same thing as demand side; increased growth,
lower unemployment, price stability and equilibrium in the foreign sector. It is therefore
not the aim which differs but the method of achieving these aims.
Policies aimed at increasing LRAS aim to:
1. Provide incentives for laborers to work more and unemployed to search for jobs
2. Increase the mobility of labor – both between jobs and between regions
3. Increase labor and capital productivity
4. Increase firms ability and willingness to invest, e.g. increase the physical capital
stock
5. Foster innovation both in production and products
6. Increase competition in the economy via privatization and ease of start-ups
7. Increase foreign direct investment (FDI) – both abroad and at home
All the above aim to increase growth over the long run without experiencing the tradeoffs common to demand-side policies.
24. State that supply-side policy may be market-based or interventionist and that
in either case they aim to shift the LRAS curve to the right, achieving growth in
potential output.
Supply side policies are government policies which seek to increase the
productivity and efficiency of the economy. They can involve interventionist
supply side policies (e.g. government spending on education) or market-based
supply side policies (e.g. reduce government legislation)
The main macro economic objectives of the government include:
1.
Higher economic growth
2.
Low inflation
3.
Low Unemployment
4.
Equilibrium on the balance of payments
5.
Distribution of income
To achieve all objectives simultaneously it is essential to improve the supply side
of the economy. If the government can increase productivity and shift AS to the
right, it can enable low inflationary growth.
24. State that supply-side policy may be market-based or interventionist and that in
either case they aim to shift the LRAS curve to the right, achieving growth in
potential output.
Market based policies:
Supply-side policies are frequently highly market orientated,
aiming to ‘liberate’ markets which are hindered from clearing
due to various forms of market ‘impurities’ such as labor
legislation, strong unions and harmful government tax laws. The
US and UK implemented many market based policies in the
1980s.
Interventionist policies:
There are however various forms of interventionist such as
increased government investment in infrastructure and education,
government re-skilling and training schemes and
regional/sectoral support in depressed areas/sectors.
Scandinavian countries have been noticeably active in this
area during the 1990s.
24. State that supply-side policy may be market-based or interventionist and that in
either case they aim to shift the LRAS curve to the right, achieving growth in
potential output.
Interventionist supply side policies:
 States have a key role in investing in public services and building
critical infrastructure
 Tax incentives and welfare reforms can encourage more people into
work
 A commitment to a fair minimum wage / living wage to improve
work incentives
 Active regional policy to boost under-performing areas / areas of
high unemployment
 Some case for selective import controls to allow domestic industries to
expand
 Management of the exchange rate to improve competitiveness of
export industries
 Nationalization of some key industries
 Stronger regulation of industries including finance and transport
24. State that supply-side policy may be market-based or interventionist and that in
either case they aim to shift the LRAS curve to the right, achieving growth in potential
output.
Market-base supply side policies:
 Cutting government spending and taxes and policies to cut
government borrowing
 Laws to control trade union powers
 Reducing red-tape to cut the costs of doing business
 Measures to improve the flexibility of the labor market /
reforming employment laws
 Policies to boost competition such as deregulation and tough
anti-monopoly and anti-cartel laws
 Privatization of state assets (selling off public sector
businesses into the private sector)
 Opening up an economy to overseas trade and investment
 Opening up an economy to inward labor migration
24. State that supply-side policy may be market-based or interventionist and that in
either case they aim to shift the LRAS curve to the right, achieving growth in potential
output.
Classical view of LRAS shifting
to the right.
Keynesian view of LRAS
shifting to the right.
25. Explain how investment in education and training will raise the levels of
human capital and have a short-term impact on aggregate demand, but more
importantly will increase LRAS.
Increased Spending on Education and Training:
Economists disagree about the scale of the likely economic and social returns to be earned
from higher spending on education – but few of them deny that “investment in education”
has the potential to raise the skills within the work force and improve the employment
prospects of thousands of unemployed workers.
The economic returns from extra education spending vary according to the stage of
development that a country has achieved
Government spending on education and training improves workers’ human capital
Economies that have invested heavily in education are those that are well set for the future.
Most economists agree, with the move away from industries that required manual skills to
those that need mental skills, that investment in education, and the retraining of previously
manual workers, is vital.
Improved training, especially for those who lose their job in an old industry should improve
the occupational mobility of workers. This should help reduce the problem of structural
unemployment.
A well-educated workforce acts as a magnet for foreign investment in the economy.
Improved education increases opportunities which means that incentives can work more
effectively
25. Explain how investment in education and training will raise the levels of human
capital and have a short-term impact on aggregate demand, but more importantly will
increase LRAS.
Basically, any government
policy causing an increase in
labor market participation
increases the supply of labor.
The Graph shows how
various forms of
interventionist supply-side
policies – notably education,
(re-) training and greater
labor mobility – increase the
aggregate supply of labor.
This in turn increases the
potential output in the
economy, LRAS.
25. Explain how investment in education and training will raise the levels of human
capital and have a short-term impact on aggregate demand, but more importantly will
increase LRAS.
Investment in human capital as a result of government intervention takes on some of the
following range of interventionism:







Government grants/subsidies to employers hiring youths, older workers and long term
unemployed
Entrepreneurial incentives such as soft loans and subsidized rent for start-up companies
and R&D loans
Government tax incentives to firms which invest in education/training amongst
employees risking redundancy
Government/communal re-training schemes
Improved information for job-seekers by way of government employment agencies, online job seeking and help/advice in job seeking
Regional support and outsourcing of government agencies to depressed areas
Specific youth training programs and subsidies for firms hiring under-18s (which will
give these young people much needed experience to gain ‘real’ jobs)
25. Explain how investment in education and training will raise the levels of human
capital and have a short-term impact on aggregate demand, but more importantly will
increase LRAS.
26. Explain how policies that encourage research and development
will have a short-term impact on aggregate demand, but more
importantly will result in new technologies and will increase LRAS.
Research and Development (R&D):
Investigate activities that a business chooses to conduct with the
intention of making a discovery that can either lead to the
development of new products or procedures, or to improvements
of existing products or procedures.
Research and development is one of the means by which
business can experience future growth by developing new
products or processes to improve and expand their operations.
Capital investment and innovation:
 Capital spending by firms adds to aggregate demand
(C+I+G+(X-M)) but also has an important effect on long run
aggregate supply.
 Supply side policies would include tax relief on research and
development and reductions in the rate of corporation tax
26. Explain how policies that encourage research and development will
have a short-term impact on aggregate demand, but more importantly
will result in new technologies and will increase LRAS.
A to B: Investment increases and AD shifts from AD0 to AD1, taking the economy from point
A to point B.
B to C: In due course, the effects of increased capital will increase productivity, causing
aggregate supply to increase from SRAS0 to SRAS1; point C.
Increase in LRAS: The increase in productivity and output capability causes LRAS to increase
from LRAS0 to LRAS1, creating new long run equilibrium at YNRU1.
27. Explain how increased and improved infrastructure will have a
short-term impact on aggregate demand, but more importantly will
increase LRAS.
Investment in infrastructure:
infrastructure is the stock of fixed capital equipment in a
country, including factories, roads, schools, etc., considered
as a determinant of economic growth.
Improving information and investing in infrastructure will
facilitate the firms to produce more and at a more cost
efficient manner.
Better infrastructure attracts more investment both domestic
and foreign. In the short run increase government
expenditures of infrastructure will lead to rise in AD and
will fuel inflation, however in the long run it will lead to
greater efficiencies and output thus shifting the LRAS to the
right.
27. Explain how increased and improved infrastructure will have a shortterm impact on aggregate demand, but more importantly will increase
LRAS.
When economists use the term infrastructure, they are referring to the ‘internal
skeleton’ which holds an economy upright and moving.
Infrastructure provides the basis for an economy to function, and consists of the
system of road networks, telecommunications networks, sewage facilities, water
supply, electricity and power sources, financial/education/health system, public
transportation networks and ports/harbors or other international points of trade
access.
An increase in infrastructure will initially increase aggregate demand.
Infrastructure is vital to a well-functioning economy and the effects of
investment here are hard to overestimate.
It allows all the factors of production in a country to be productively utilized:
laborers can get to their jobs; produce can be transported to urban areas from
rural areas; power, water and information so vital to firms can be transported;
and enhanced market accessibility increases the level of competition in an
economy.
28. Explain that targeting specific industries through policies including tax cuts, tax
allowances and subsidized lending promotes growth in key areas of the economy and will
have a short-term impact on aggregate demand but, more importantly, will increase LRAS.
Improving the performance of firms
Measures to improve competition and efficiency in product markets, especially in global
markets, are also a significant part of supply-side policy. Example of measures include:
 Government may help to improve supply-side performance by giving assistance to
firms to encourage them to use new technology, and innovate. This can be done
through grants, or through the tax system.
 Deregulation of product markets may be implemented to bring down barriers to
entry, encourage new and dynamic market entrants, and improve overall supplyside performance. The effect of this would be to make markets more competitive
and increase efficiency. Promoting competition is called competition policy.
 Privatization of state industry was a central part of supply-side policy during the
1980s and 1990s, and helped contribute to the spread of an enterprise culture. As
long as privatization is accompanied by measures to promote competition, there are
likely to be efficiency gains for the firm, and productivity gains for the employees.
 Supply side performance can also be improved if there is a constant supply of new
firms. Small businesses are often innovative and flexible, and can be helped in a
number of ways, including start-up loans and tax breaks.
28. Explain that targeting specific industries through policies including tax cuts, tax
allowances and subsidized lending promotes growth in key areas of the economy and will
have a short-term impact on aggregate demand but, more importantly, will increase LRAS.
The following industrial policies can increase long run
potential:
 R&D grants to firms together with government support
for R&D units linked to state universities
 Regional support for fledgling industries
 Relocation subsidies for workers to seek and take
jobs in other regions
 Active promotion of Home Country industries and
products via trade legations at embassies abroad
29. Explain how factors including deregulation, privatization, trade
liberalization and antimonopoly regulation are used to encourage
competition.
Deregulation of Markets:
 De-regulation or liberalization means the opening up
of markets to greater competition
 The aim of this is to increase market supply (driving
prices down) and widen the choice available to
consumers
 Good examples of deregulation to use include: urban
bus transport, post and parcel delivery service,
telecommunications, and gas and electricity supply.
29. Explain how factors including deregulation, privatization, trade
liberalization and antimonopoly regulation are used to encourage
competition.
29. Explain how factors including deregulation, privatization, trade
liberalization and antimonopoly regulation are used to encourage
competition.
Privatization:
Over the last twenty-five years, many former stateowned businesses have been privatized – i.e.
transferred from the public to private sector.
Privatization is designed to break-up state monopolies
and create more competition.
The government also created utility regulators who
have in the past imposed price controls and who are
now in charge of over-seeing moves towards competitive
markets in areas such as gas and electricity supply and
telecommunications.
29. Explain how factors including deregulation, privatization, trade
liberalization and antimonopoly regulation are used to encourage
competition.
29. Explain how factors including deregulation, privatization, trade
liberalization and antimonopoly regulation are used to encourage
competition.
Toughening up of Competition Policy:
 Most supply-side economists believe that competition forces
business to become more efficient in the way in which they
use scarce resources.
 A tougher competition policy regime includes policies
designed to curb anti-competitive practices such as pricefixing cartels and other abuses of a dominant market
position – in other words – intervention to curb some of the
market failure that can come from monopoly power
29. Explain how factors including deregulation, privatization, trade
liberalization and antimonopoly regulation are used to encourage
competition.
Measures to encourage small business start-ups /
entrepreneurship:
 The small businesses of today often become the larger
businesses of tomorrow employing more workers and
contributing to innovation that can have positive spill-over
effects in other industries.
 Governments of all political persuasions argue that they
want to promote an entrepreneurial culture and to
increase the rate of new business start-ups.
 Supply side policies include loan guarantees for new
businesses; regional policy assistance for entrepreneurs in
depressed areas of the country; advice for new firms
30. Explain how factors including reducing the power of labor unions, reducing
unemployment benefits and abolishing minimum wages are used to make the
labor market more flexible (more responsive to supply and demand).
Reducing the power of Trades Unions:
 This should a) increase efficiency of firms e.g. less time lost to
strikes
b) reduce unemployment ( if labor markets are competitive)
Reducing State Welfare Benefits
 This may encourage unemployed to take jobs.
Providing better information about jobs
 This may also help reduce frictional unemployment
Deregulate Labor Markets
 This is said to be an important objective to increase
competitiveness. E.g. Make it easier to hire and fire workers.
30. Explain how factors including reducing the power of labor unions, reducing
unemployment benefits and abolishing minimum wages are used to make the
labor market more flexible (more responsive to supply and demand).
31. Explain how factors including personal income tax cuts are used to increase
the incentive to work, and how cuts in business tax and capital gains tax are
used to increase the incentive to invest.
Income Tax Reforms and the Incentive to Work:


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Economists who support supply-side policies believe that lower rates of
income tax provide a short-term boost to demand, and they improve
incentives for people to work longer hours or take a new job –
because they get to keep more of the money they earn.
Cutting tax rates for lower paid workers may help to reduce the
extent of the ‘unemployment trap’ – where people calculate that they
may be no better off from working than if they stay outside the labor
force.
Do lower taxes always help to increase the active labor supply in the
economy? It seems obvious that lower taxes should boost the incentive
to work because tax cuts increase the reward from a job. But some
people may choose to work the same number of hours and simply
take a rise in their post-tax income! Millions of other workers have
little choice over the hours that they work.
31. Explain how factors including personal income tax cuts are used to increase
the incentive to work, and how cuts in business tax and capital gains tax are used
to increase the incentive to invest.
Reductions in business taxation:
For example lowering the rate of corporation tax (to
stimulate investment) or reducing employers’ national
insurance contributions (to boost the demand for labor).
Lower taxes for business research and development
spending or tax relief for inward investment projects also
have a supply-side aspect to them.
capital gains tax cuts: Encourages investors to retain
funds for a long period. Facilitates investment in new
equipment and machinery.
31. Explain how factors including personal income tax cuts are used to increase the
incentive to work, and how cuts in business tax and capital gains tax are used to increase
the incentive to invest.
31. Explain how factors including personal income tax cuts are used to increase the
incentive to work, and how cuts in business tax and capital gains tax are used to
increase the incentive to invest.
It is argued that lower taxes
(income and corporation) increase
the incentives for people to work
harder, leading to more output.
The Laffer curve is a
representation of the relationship
between government revenue
raised by taxation and possible
rates of taxation.
It illustrates the concept of taxable
income elasticity – that taxable
income will change in response to
changes in the rate of taxation.
31. Explain how factors including personal income tax cuts are used to increase the
incentive to work, and how cuts in business tax and capital gains tax are used to
increase the incentive to invest.
The Laffer curve usually postulates that
no tax revenue will be raised at the
extreme tax rates of 0% and 100%.
If both a 0% and 100% rate of taxation
generate no revenue, but some
intermediate tax rate generates some
tax revenue, it follows that there must
exist at least one rate where tax revenue
would be a non-zero maximum.
The Laffer curve is typically represented
as a graph which starts at 0% tax with
zero revenue, rises to a maximum rate of
revenue at an intermediate rate of
taxation, and then falls again to zero
revenue at a 100% tax rate.
The actual existence and shape of the
curve is uncertain and disputed.
32. Evaluate the effectiveness of supply-side policies through consideration of factors including time
lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on
economic growth, the impact on the government budget, the effect on equity, and the effect on the
environment.
Time lags:
Supply-side policy can take a long time to work its way
through the economy.
For example, improving the quality of human capital,
through education and training, is unlikely to yield quick
results.
The benefits of deregulation can only be seen after
new firms have entered the market, and this may also
take a long time.
32. Evaluate the effectiveness of supply-side policies through consideration of factors including time
lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on
economic growth, the impact on the government budget, the effect on equity, and the effect on the
environment.
The ability to create employment:
They can also help create real jobs and sustainable growth through their
positive effect on labor productivity and competitiveness.
Furthermore, some specific types of supply-side policy may be strongly
resisted as they may reduce the power of various interest groups.
For example, in labor markets the interests of trade unions may be
threatened by labor market reforms.
Power of labor unions, reducing unemployment benefits and abolishing
minimum wages can lead to wide spread discontent among the labor
force in the economy.
Thus governments are usually hesitant in taking these steps. Moreover,
these might also lead to worsening of working conditions in the long run
which will affect labor productivity.
32. Evaluate the effectiveness of supply-side policies through consideration of factors including time
lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on
economic growth, the impact on the government budget, the effect on equity, and the effect on the
environment.
Suggested Supply Side Policies to Reduce Unemployment
 Better job information to help reduce frictional unemployment.
 Lower unemployment benefits to increase the incentive to get a job. It is argued
generous unemployment benefits create an unemployment trap, where those on benefits
would get only a small increase in after tax income if they decided to work.
 Reduced Power of Trades Unions. Trades unions can cause real wage / classical
unemployment (where wages are pushed above the equilibrium. If you reduce the
power of unions, wages will fall to equilibrium levels leading to less unemployment. Also
reducing minimum wages should have similar effect. However, this could leave workers
without protection against monopsonist employers leading to lower wages.
 Better education and training. This provides skills which will help the long-term
unemployed to retrain and find jobs in a fast changing labor market. This can help
reduce structural unemployment. However, it depends whether the government can
provide skills that employers really need; there is no guarantee that government
spending will be able to solve the skills gap.
Demand Deficient Unemployment
 Supply side policies will not reduce unemployment caused by a fall in aggregate
demand (demand-deficient unemployment) They can only reduce long term structural
unemployment.(natural rate of unemployment)
32. Evaluate the effectiveness of supply-side policies through consideration of factors including time
lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on
economic growth, the impact on the government budget, the effect on equity, and the effect on the
environment.
The ability to reduce
inflationary pressure:
Supply-side policies can help
reduce inflationary pressure in
the long term because of
efficiency and productivity
gains in the product and labor
markets.
Supply side policies appear to
answer the problem of
stagflation. By increasing
aggregate supply, both falling
real GDP and inflation can be
revered.
32. Evaluate the effectiveness of supply-side policies through consideration of factors including time
lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on
economic growth, the impact on the government budget, the effect on equity, and the effect on the
environment.
The impact on economic growth:
They can also help create real jobs and sustainable growth through
their positive effect on labor productivity and competitiveness.
 Supply-side policies are mainly micro-economic policies aimed at
making markets and industries operate more efficiently and
contribute to a faster underlying-rate of growth of real national
output
 Successful policies have the effect of shifting the LRAS curve to the
right leading to a rise in potential output
 Most governments believe that improved supply-side performance
is the key to achieving sustained growth without causing a rise in
inflation.
 Supply-side reform on its own is not enough to achieve this growth.
There must also be a high enough level of AD so that the
productive capacity of an economy is actually brought into play.
32. Evaluate the effectiveness of supply-side policies through consideration of factors including time
lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on
economic growth, the impact on the government budget, the effect on equity, and the effect on the
environment.
The impact on the government budget:
Supply-side policy is very costly to implement and have
severe impact on the government budget.
For example, the provision of education and training is highly
labor intensive and extremely costly. The government has to
carefully plan these spending over a period of time.
In the short run market oriented supply side policies such as
reducing in income and corporate taxes can reduce
government’s main source of revenue, however in the long run
size of the economic growth would be significant enough that
the increased government revenue from a faster growing
economy would cause overall revenue to increase.
32. Evaluate the effectiveness of supply-side policies through consideration of factors including time
lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on
economic growth, the impact on the government budget, the effect on equity, and the effect on the
environment.
The effect on equity:
Many supply-side measures
have a negative effect on
the distribution of income, at
least in the short-term. For
example, lower taxes rates,
reduced union power, and
privatization have all
contributed to a widening of
the gap between rich and
poor.
32. Evaluate the effectiveness of supply-side policies through consideration of factors
including time lags, the ability to create employment, the ability to reduce inflationary
pressure, the impact on economic growth, the impact on the government budget, the effect
on equity, and the effect on the environment.
The effect on the
environment:
Supply side policies can lead
to exploitation of natural
resources and environment if
environmental regulations are
relaxed thus creating
negative externalities of
production.
The social cost of
deregulation may be borne
out in unsafe products,
dangerous work places and
polluted environments.
32. Evaluate the effectiveness of supply-side policies through consideration of factors including time
lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on
economic growth, the impact on the government budget, the effect on equity, and the effect on the
environment.
The advantages:
 Supply-side policies can help reduce inflationary
pressure in the long term because of efficiency and
productivity gains in the product and labor markets.
 They can also help create real jobs and sustainable
growth through their positive effect on labor productivity
and competitiveness. Increases in competitiveness will
also help improve the balance of payments.
 Finally, supply-side policy is less likely to create conflicts
between the main objectives of stable prices, sustainable
growth, full employment and a balance of payments.
This partly explains the popularity of supply-side policies
over the last 25 years.
32. Evaluate the effectiveness of supply-side policies through consideration of factors including time
lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on
economic growth, the impact on the government budget, the effect on equity, and the effect on the
environment.
The disadvantages:




However, supply-side policy can take a long time to work its way through the
economy. For example, improving the quality of human capital, through
education and training, is unlikely to yield quick results. The benefits of
deregulation can only be seen after new firms have entered the market, and
this may also take a long time.
In addition, supply-side policy is very costly to implement. For example, the
provision of education and training is highly labor intensive and extremely
costly, certainly in comparison with changes in interest rates.
Furthermore, some specific types of supply-side policy may be strongly
resisted as they may reduce the power of various interest groups. For
example, in product markets, profits may suffer as a result of competition
policy, and in labor markets the interests of trade unions may be threatened
by labor market reforms.
Finally, there is the issue of equity. Many supply-side measures have a
negative effect on the distribution of income, at least in the short-term. For
example, lower taxes rates, reduced union power, and privatization have all
contributed to a widening of the gap between rich and poor.
32. Evaluate the effectiveness of supply-side policies through consideration of factors including time
lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on
economic growth, the impact on the government budget, the effect on equity, and the effect on the
environment.
Demand-Side Vs. Supply-Side Policies
Demand- and supply-side economics are both based on the general
faith in markets. In both cases, the differing views suggest that
markets are essentially rational allocators of resources and
rewards, but the engine of that market is the area of difference.
These two schools of economics seek the alleviation of
unemployment and the most rational uses of government to achieve
the ends of rational and justifiable rewards.
Government Policies
Governments have a fairly limited arsenal of policy weapons to use
in the economy. Taxation and regulation are always the two major
sources of government intervention. In addition to those,
governments can buy industry, promote public works, increase
welfare and unemployment payments, start wars, restrict imports
and mobilize labor. These government weapons in the economy are
seen very differently by demand- and supply-side economists.
32. Evaluate the effectiveness of supply-side policies through consideration of factors including time
lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on
economic growth, the impact on the government budget, the effect on equity, and the effect on the
environment.
Supply-side Policies
Supply side, as the name suggests, takes the producers and investors of wealth as
the main engine of economic development. The basic argument is that the producers
and investors need a set of incentives to promote investment and innovation. This set
of incentives requires the state -- seen as an unproductive and parasitical entity -- to
reduce taxes on those groups and classes most likely to invest their money wisely in
production and innovation. Therefore, taxes should be low, budgets should be
balanced, regulation kept at a minimum and international trade should be kept
free.
Demand-side Policies
The demand side takes most of its theoretical work from the British economist John
Maynard Keynes. He held that the real engine of economic development comes at
the level of the consumer. Therefore, governments should be deeply involved in the
economy. If the consumer -- and therefore, demand -- is the engine of economic
growth, then the state should do all in its power to increase the spending power of
the average person. This, in turn, requires that the state engage in public works and
increase all forms of entitlements. Full employment is the goal of the demand-side
economist, and it matters not where the source of that employment is. All that
matters is that consumers continue to buy products and services, and keep the
economy spinning.
32. Evaluate the effectiveness of supply-side policies through consideration of factors including time
lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on
economic growth, the impact on the government budget, the effect on equity, and the effect on the
environment.
States and Markets
These two schools of thought, while believing in the market mechanism, view
the market differently.
The supply-side advocate sees markets as closed, self-contained units. They
are inherently rational since consumer demand is quickly translated into prices
that then send signals to producers to make more of an item.
Demand-side advocates hold that there is no real reason to believe that
cutting taxes will mean that producers and investors will rationally invest their
saved money. The differing views on government policy relative to markets
are based on the two schools' views on human rationality.
For the supply-side advocate, low taxes and minimal regulation will lead to
rational outcomes, since everyone wants to profit.
The demand-side will hold that the market does not guarantee full
employment and therefore is self-defeating, since the unemployed cannot buy
anything. The investor is just as likely to invest in non-productive things as in
productive things. Policy matters here because the government can "fill in"
where the market fails.
Supply-Side vs Demand-Side Policies
DEMAND-SIDE POLICY: an economic theory that
advocates use of government spending and growth in
the money supply to stimulate the demand for goods
and services and therefore expand economic activity.
SUPPLY-SIDE POLICY: an economic theory that
reduction of tax rates encourages more earnings,
savings, and investment and thereby expands
economic activity and the total taxable national
income.
Advantages & Disadvantages of demand side policies:
Advantages:
By using demand side policies it is possible to influence
the level of economic activity and therefore output,
unemployment, inflation and the trade balance.
It helps to achieve macro- economic goals. Automatic
stabilizers help even out economic cycles and create
stability and predictability in the economy.
Discretionary fiscal policy allows government to steer
the economy in line with economic goals and economic
welfare.
Advantages & Disadvantages of demand side policies:
Disadvantages:
Inflation
 Inflation is the leading disadvantage of demand-side economics. The demand-side
perspective argues that the market economy, left to its own devices, will not ensure
sufficient adequate demand, which means that society will not utilize its full production
capacity.
Budget Deficits
 During a recession or other economic slowdown, output declines as a result of reduced
activity. Higher government spending to compensate for the decline in aggregate
demand is generally financed by borrowing, which increases government deficits and
raises the national debt.
Policy Lags
 The problem is the lag between recognition of the need for government action and the
actual implementation of appropriate policy measures. Often, the policy-making
process itself is responsible for the delay in the adoption and implementation of policy
measures. Further, there is an additional lag between the policy itself and the effects
resulting from it. Often, many months may elapse between a change in government
economic policy and the policy's effect on the economy.
Advantages & Disadvantages of supply- side policies:
The advantages:
 Supply-side policies can help reduce inflationary
pressure in the long term because of efficiency and
productivity gains in the product and labor markets.
 They can also help create real jobs and sustainable
growth through their positive effect on labor productivity
and competitiveness. Increases in competitiveness will also
help improve the balance of payments.
 Finally, supply-side policy is less likely to create conflicts
between the main objectives of stable prices, sustainable
growth, full employment and a balance of payments.
Advantages & Disadvantages of supply- side policies:
The disadvantages:
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However, supply-side policy can take a long time to work its way through the
economy. For example, improving the quality of human capital, through
education and training, is unlikely to yield quick results. The benefits of
deregulation can only be seen after new firms have entered the market, and
this may also take a long time.
In addition, supply-side policy is very costly to implement. For example, the
provision of education and training is highly labor intensive and extremely
costly, certainly in comparison with changes in interest rates.
Furthermore, some specific types of supply-side policy may be strongly
resisted as they may reduce the power of various interest groups. For example,
in product markets, profits may suffer as a result of competition policy, and in
labor markets the interests of trade unions may be threatened by labor
market reforms.
Finally, there is the issue of equity. Many supply-side measures have a
negative effect on the distribution of income, at least in the short-term. For
example, lower taxes rates, reduced union power, and privatization have all
contributed to a widening of the gap between rich and poor.