Supply-side Policy, Policy Conflicts and Effectiveness

Supply-side policy

Supply-side policies aim to increase the productive capacity of the economy, shifting LRAS to the right, by improving the quantity and quality of factors of production and the efficiency with which markets work. Market-based measures reduce government intervention: cutting marginal income tax rates to raise work incentives, cutting corporation tax to raise investment, reducing benefits, weakening trade union power, deregulation and privatisation, and trade liberalisation. Interventionist measures involve more government: spending on education and training, infrastructure, subsidies for research, and regional policy. If successful, they raise growth, lower the natural rate of unemployment, reduce inflationary pressure and improve the current account at the same time, which no demand-side policy can do. Their weaknesses are time (a decade for education), cost, uncertainty of effect (tax cuts may be saved rather than worked for), and distributional effects (benefit cuts widen inequality).

Policy conflicts

Governments pursue growth, low unemployment, low inflation, a sustainable balance of payments, and often equity and environmental goals. With demand-side tools these conflict: expansion lowers unemployment but raises inflation (the Phillips curve) and sucks in imports (worsening the current account); contraction to cure inflation or a deficit raises unemployment. Fiscal expansion may crowd out private investment through higher interest rates, and if the central bank responds by raising rates the two policies work against each other. A fixed exchange rate removes monetary policy independence. Tinbergen's rule: one instrument per objective.

Judging effectiveness

The effect of any policy depends on: the size of the output gap and the slope of AS; the size of the multiplier; time lags; the state of confidence; the exchange rate regime; the credibility of the policymaker; and side effects on other objectives. The usual A2 conclusion is that demand-side policy manages the cycle while supply-side policy raises the trend, and that the best mix depends on the diagnosis.