The relative merits of demand-side and supply-side policies
In the unit
exam, particularly for the “
mark” question, you may be required to use demand
side and/or supply side policies in your analysis. You need to understand what is meant by these
two terms and how you can use them in conjunction with AS/AD diagrams to get high marks in the
exam.
Demand-side policies
When we refer to a ‘policy’ we mean a government policy (ie a tool it uses to control the economy).
Demand-side policies are, therefore, government policies that affect the demand-side of the
economy (i.e. affect AD in the AS/AD diagram). The syllabus refers to fiscal policy and monetary
policy.
1.
Fiscal policy refers to any government policy associated with
. If the government decide to spend more/less money on education or
increase/decrease welfare payments, or change the rates of direct and/or indirect taxes, then
this is described as fiscal policy. The syllabus also requires you to understand fiscal policy in
terms of injections and withdrawals. Using the examples above, new money spent on
education counts as an injection, where as the rise in income tax counts as a withdrawal. It is
also important that you understand how these different examples of fiscal policy affect the
AS/AD diagram. The rise in government spending will shift the AD curve to the right, and the
rise in income tax will shift the AD curve to the left. You can probably think of other examples
that the examiner could use.
You are also required to understand the terms
. If a
government, over the course of a year, spends more than it receives in tax revenues, then it is
said to have a budget deficit. On the other hand, if the tax receipts are larger than government
spending over the year, then the government has recorded a budget surplus. The UK tends to
record budget deficits, although it did have surpluses in the late 1980s and the late 1990s.
Finally, you need to be able to analyse the consequences of, for example, a budget deficit. It
could be argued that persistent budget deficits will mean that the government will have to cut
back on government spending in the future or increase taxes in order to reduce the budget
deficit. Clearly a large budget deficit will put constraints on the use of fiscal policy in the future.
A government may want to increase AD through an increase in government spending, but
may be forced not to due to a massive budget deficit.
2.
Nowadays, monetary policy is basically the setting of interest rates with the inflation target as
the goal. Although the government still set the inflation target (currently %
% based on the CPI), the job of setting rates has, since 1997, belonged to the Monetary
Policy Committee (MPC) of the Bank of England. The nine members meet once a month to
discuss factors that will affect the inflation rate over the medium term (up to two years). These
factors include retail sales figures, the housing market, the exchange rate and many others.
Each member has a vote, the decision is announced on the first Thursday every month, and
the minutes of the meeting are published a couple of weeks later.
In terms of the effect on AD, a rise in interest rates will tend to reduce AD, through higher
mortgage repayments (and so lower consumption), lower investment by firms and a higher
exchange rate (which makes exports more expensive and imports cheaper). A cut in interest
rates will have the reverse effect.
Supply-side policies
What are supply-side policies?
Supply side policies are those that improve the supply side of the economy. In other
words, they are government policies that increase the amount of ‘supply’ that is capable of
being produced over the long term. They improve the productive potential of the economy.
Diagrammatically, it can be illustrated by an outward shift in the production possibility
frontier (PPF), or a shift to the right of the long run aggregate supply curve (LRAS
curve). In the next two sub-sections you will see that Keynesian and Monetarist (and
classical) economists disagree about the need for these policies. First we shall look at
some examples of these policies. They can be split into those to do with the product
market and those linked to the labour market.
Product market supply-side policies
All of the policies in the product market are designed to increase competition, and so
efficiency. If the productivity of an industry improves, then it will be able to produce more
with a given amount of resources, shifting the LRAS curve to the right. All of the following
policies are, in some way or another, trying to increase the level of competition in product
markets.
1.
. This was the major supply side policy on the product market side
of the 1980s. The privatisation of various large industries (telecoms, electricity, gas,
etc.) was designed to break up the state monopolies to create more competition. Of
course, many of these privatisations simply turned public sector monopolies into
private sector monopolies, but there have been efforts to introduce competition into
these industries. You may have seen the numerous TV adverts by lots of companies
selling gas and electricity. There is clearly a lot more competition in the telecoms
market than ten years ago. Some large companies were also privatised, so that they
would be exposed to the rigours of the market. British Airways is an example. We will
be looking at privatisation in a lot more detail in unit four of the A2 syllabus.
2.
. This is another form of privatisation. The best example is the
deregulation of the bus industry. Competition was certainly increased, but many
questioned whether the quality of services remained the same. Some economists
would include the deregulation of the capital markets (1979) and the stock exchange
(1986) in this section.
3.
. This may not seem like a ‘policy’ as such, but it does
symbolise a country’s commitment to ‘free trade’ given that the main goal of the
WTO is to remove barriers to world trade. World real output is higher than it would
otherwise be when tariffs are removed and trade is free.
4.
. In particular, small businesses. The governments of
the 1980s encouraged enterprise with various grants, reductions in small business
tax rates and tax breaks for investment. The new Labour government has also
helped with training for those thinking of starting a business and guarantees on bank
loans for those that would have had no chance of getting a bank loan otherwise.
Labour market supply-side policies
The following policies are all designed to improve the quality and quantity of labour.
Increased numbers will obviously increase the productive potential of an economy.
Increased quality will improve the productivity of labour. If a given amount of labour
increases its productivity, then they will produce more with a given set of resources, and
so the productive potential of the economy will again improve. As with the product market
policies, successful labour market supply side policies will shift the LRAS curve to the
right.
1.
. Trade unions are a barrier to the free working of a labour market.
They stop employers from negotiating the wage individually with employees and arriving at
the equilibrium wage. Unions tend to push the wage above the market equilibrium, and, in
the 1970s especially, can be quite disruptive in terms of going on strike. The governments of
the 1980s passed many laws in Parliament to reduce the power of the trade unions. This
made labour markets more flexible and efficient. You will look at this in much more detail at
A2 level – the whole of unit five is devoted to labour markets!
2.
. Some would say that this is the most important of all supply side
policies (Blair – “education, education, education”). Government spending on education and
training improves workers’ human capital. They become better quality workers. Their
productivity improves and so the LRAS curve shifts to the right. 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 absolutely vital. It should also be noted that improved training, especially for those who
lose their job in an old industry, will improve the occupational mobility of workers in the
economy.
3.
. Whilst income tax is a requirement, so that the government can
pay for important public services, there is always someone who thinks that it is too high! In
the late 1970s, very few would have disagreed. The highest marginal income tax rate was
over 80%! Even the basic rate, paid by relatively low earners, was 33%. This meant that if
you were a relatively high earner, you would pay more than 80p in every extra £1 that you
earned. Unsurprisingly, many felt that this was a disincentive to work in the labour market.
Why work harder if the government will keep most of your earnings? The governments of the
80s reduced these high marginal income tax rates to encourage more people to work hard.
The final big drop was in the Budget of 1988, when the top marginal rate fell from 60% to
40% where it remains today. Of course, indirect taxes were raised to make up for it (e.g.
VAT), but the point was to get more people to be economically active, and those already in
work might work harder.
4.
. In some countries where government spending is relatively high
(like Sweden and France), unemployment benefits are so high that the difference between
disposable income in work and benefits received out of work is small. There is little
incentive to take a job. If the unemployment benefits are very low, so low that it is difficult to
live on benefit alone, then even low paid jobs will seem attractive. Some very extreme
supply side economists believe that unemployment benefit should not exist, and this is the
case in some countries, like Tunisia, where there is no unemployment benefit at all! The
other option is to offer in-work benefits. The new Working Families Tax Credit is a benefit
that is paid through the pay packet. Whether out of work benefits are reduced or in work
benefits are increased, the idea is to create incentives for people to work and so increase
the supply of labour and the productive potential of the economy.
Why monetarists like supply-side policies
Supply side policies are very popular with classical, or monetarist, economists. The
following diagrams should explain why. We will be using long run aggregate supply curves
(LRAS curves) in this analysis.
Look at the diagram below.
You can see a ‘normal’ looking AD curve and the initial LRAS curve, LRAS1. This gives an
equilibrium level of real national income of YFE1 at a price level of P1. It is clear to see that,
given the assumption of the classical economists that the LRAS curve is vertical at all price
levels, any shift to the right of this curve due to supply side policies will be beneficial both
in terms of a higher level of real national income (YFE2) and a lower price level (P2).
The monetarist governments of the 1980s were very keen on supply side policies. Many of
these policies were long term in nature. Some economists think that the Labour
government should thank the Conservative governments of the 1980s for creating the right
economic fundamentals for healthy, but sustainable, growth to occur in the late 1990s and
beyond. As we shall see in the next section, these policies did not work in the depression
of the 1930s when there was a severe lack of demand.
The Keynesian view
Keynesian economists agree that the productive potential of the economy can be
improved with supply side policies, but stress that this is of no use if there is a depression,
or a severe recession, where a chronic lack of demand is the key problem.
As a result of supply side policies, the LRAS curve has shifted to the right, but only the
vertical part has shifted. This is still a good thing because the productive potential of the
economy has improved. A higher real national income can be achieved before the cost of
a rising price level kicks in.
But these policies are no good in times of severe recession, or depression. If an economy
is currently at a level of demand represented by AD1 (price P1, real output Y1), the increase
in the possible full employment level of real output from YFE1 to YFE2 is of no significance.
The price level and real income level both stay the same. However, if the economy has a
level of demand represented by AD2, then the supply side polices will be useful (similar to
the classical diagram above), and Keynesians would admit this fact, but in times of
depression, they argue, supply side policies are of no use. In fact, they could make things
worse. Reducing unemployment benefit at a time when unemployed workers simply
cannot get a job due to the lack of demand in the economy will make their plight even
worse. Also, they themselves will have less money to spend, thus accentuating the
problem of lack of demand (negative multiplier effect).