Macro Economics – Supply-side policies – Flashcards

Supply-side policies focus on the production and supply side of the economy, and specifically on factors aimed at shifting the long-run aggregate supply (LRAS) or Keynesian AS curves to the right, to increase potential output and achieve long-term economic growth. hey do not attempt to stabilise the economy by reducing the severity of the business cycle. Instead, they focus on increasing the quantity and quality of factors of production, as well as on institutional changes intended to improve the productive capacity of the economy. There are two major categories of supply-side policies: interventionist and market-based. Interventionist policies rely on government intervention to achieve growth in potential output, and are usually favoured by economists influenced by Keynesian economic thinking. Market-based policies emphasise the importance of well-functioning competitive markets in achieving growth in potential output, and are usually favoured by monetarist/new classical economists.

4. Investment in human capital, investment in new technology, investment in infrastructure and industrial policies

Investment in human capital is investment in education and training of a population or generation. This can be done by; 1. investing in training and education or 2. improving health care services and access to these. Investments in human capital can result in an increase in aggregate demand over the short term, and over the long term can lead to increases in potential output by shifting the LRAS curve to the right.

More and better training and education lead to an improvement in the quality of labour resources, increasing the productivity of labour, which is one of the key causes of economic growth. Education, you may also remember, has numerous positive externalities, thereby justifying government intervention. Public training and education programmes can assist workers to become more employable, thus reducing the natural rate of unemployment. Specific measures include setting up retraining programmes for structurally unemployed workers to obtain skills in greater demand; assisting young people to pursue training and education through grants or low interest loans; direct government hiring and provision of on-the-job training; providing grants to firms that offer on-the-job training; offering subsidies to firms that hire structurally unemployed workers; assisting workers to relocate to geographical areas where there is a greater demand for labour through grants and subsidies (such as provision of low-cost housing); providing information on job availability in various geographical areas; establishing government projects in the depressed areas that result in new employment creation.

When workers (and the general population) have access to good quality health care services, they become healthier and more productive. Improved health care services and access to these by the working population is therefore another factor leading to improvements in the quality of labour resources, increasing the economy's potential output. Health care also has many positive externalities, justifying government intervention.

Research and development is fundemental behind the development of new technology. It results in new or improved capital goods, which leads to increases in potential output and economic growth. This has positive externalities justifying government intervention. Government spending in support of new technology leads to an increase in AD in the short term and increases in potential output in the long-run by shifting the LRAS curve to the right.

Infrastructure is a type of physical capital and therefore results in investment. Many types of infrastructure qualify as merit or public goods. There more of and better infrastructure increases efficiencies in production as it lowers costs. It also improves labour productivity. Investments in infrastructure therefore increase AS over the short term, but also contributes to increases in potential output and LRAS increases over the long-term.

Industrial policies are government policies designed to support the growth of the industrial sector of an economy. All policies considered above, government investments in human capital, new technologies and infrastructure are industrial policies.

1. Support for small and medium-sized enterprises or firms (SMEs) 2. Support for 'infant industries'

Governments can provide support to small and medium-sized firms, which may take the form of tax exemptions, grants, low-interest loans and business guidance. This provides support for the private sector, promoting efficiency, more capital formation, more employment possibilities and therefore increases aggregate demand as well as potential output.

'Infant industries' are newly emerging industries in developing countries, which sometimes receive government support in the form of grants, subsidies, tax exemptions, and tariffs or other forms of protection against exports. This also provides support for growth of the private sector and increases in aggregate demand and growth in potential output.

The focus of government policies is on stabilisation, and more on creating conditions that allow market forces to work well. This perspective suggests that an economy pursuing supply-side policies will be able to achieve rapid growth, price stability and full employment all at the same time. These advantages are seen to arise because as the economy tends towards full employment equilibrium, it automatically eliminates recessionary and inflationary gaps, thus eliminating the problem of unemployment in recessionary gaps, and the problem of inflation in inflationary gaps. Market-based supply-side policies can be grouped under three headings: 1. Policies to encourage competition 2. Labour market reforms 3. Incentive related policies

Greater competition among firms forces them to reduce costs, contributing to greater efficiency in production and improving the allocation of resources. Releasing resources ad making them more productibe allows potential output to increase and the LRAS curve to shuft to the right, this can be done by; -privatisation - deregulation - private financing of public sector projects - contracting out to the private sector - restricting monopoly power - trade liberalisation

Privatisation, involving a transfer of ownership of a firm from the public to the private sector, can increase efficiency due to improved management and operation of the privatised firm. This is based on the argument that government enterprises are often inefficient as they have bureaucratic procedures, high administrative costs and unproductive workers, because they do not face incentives to lower costs and maximise profits. The private sector may therefore be more efficient than the public sector.

Deregulation involves the elimination or reduction of government regulation of private sector activities, and is based on the argument that government regulation stifles competition and increases inefficiency. There are two main types of regulation (and deregulation): economic and social. 'Economic regulation' involves government control of prices, output, and other activities of firms, offering them protection against competition. A main form of deregulation has been to allow new, private firms to enter into monopolistic or oligopolistic industries, thus forcing existing firms to face competition. 'Social regulation' involves protecting consumers against undesirable effects of private sector activities (many of these involve negative externalities) in numerous areas, including food, pharmaceutical and other product safety, worker protection against injuries, and pollution control. In contrast to economic regulation, social regulation is being strengthened in many countries in the interests of public safety. Some economists, however, argue that social regulation is excessive, giving rise to costly and inefficient bureaucratic procedures, paperwork and unnecessary government interference, and should therefore be reduced.

Historically, public sector projects (such as building roads, harbours, airports, schools, hospitals and other infrastructure) have been financed out of the government budget (tax revenues). In more recent years, a number of countries have introduced private financing of public projects, called private financing initiatives, where a private firm builds, finances and operates public services. The capital and services are owned by the private company, and the government buys the services from the private firm. Such initiatives increase competition, because private sector firms compete with each other to be selected by the government to take on the project; the government selects the private firm that offers to build and run the service at the lowest cost and provide the best quality.

Here, public services are provided by private firms based on a contractual agreement between the government and the private service provider. Examples include information technology, human resources management and accounting services. These result in increased competition as private firms compete with each other to get contracts with the government, thereby resulting in improved efficiency, lower costs of production and improved quality.

Increased competition can result from restricting monopoly power of firms by enforcing anti-monopoly legislation, by breaking up large firms that have been found to engage in monopolistic practices into smaller units that will behave more competitively, and by preventing mergers between firms that might result in too much monopoly power. Greater scope for the forces of supply and demand may result in increased efficiency, lower costs and improved quality.

International trade between countries has become freer in recent decades due to reductions in trade barriers. This topic will become clearer after you read Chapter 14, where you will discover that according to economic theory, free or freer trade increases competition between firms both domestically and globally, resulting in greater efficiency in production and an improved allocation of resources.

Labour market reforms are sometimes referred to as increasing labour market flexibility. These reforms are intended to make labour markets more competitive, to make wages respond to the forces of supply and demand, to lower labour costs and increase employment, this can be done by; - abolishing minimum wage legislation - weakening the power of labour (trade) unions - reducing unemployment benefits - reducing job security

Elimination or reduction of the legal minimum it is argued, reduces unemployment by allowing the equilibrium wage to fall. The benefits of increased wage flexibility (in the downward direction) would include lower unemployment, since firms can hire more labour at the lower wage; greater firm profits, as wage costs would be lowered; more investment and economic growth.

Unionised labour frequently succeeds in securing high wage increases; if labour unions are weakened, wages will be more responsive to the forces of supply and demand, and will therefore be more likely to fall in the event that there is unemployment. This would also lead to increased wage flexibility with the same benefits as in the case of abolishing minimum wage legislation.

Unemployment benefits are payments to workers who have lost their jobs, and are meant to provide some income to the unemployed during the period of time they are searching for a new job. It is argued that unemployment benefits have the unintended effect of reducing the incentive to search for a new job, causing some unemployed workers to remain unemployed for longer periods than necessary. Therefore, reducing unemployment benefits is expected to lower unemployment, as it would encourage the unemployed to look for work. This could work to reduce the natural rate of unemployment.

Many countries have laws that protect workers against being fired, making it costly for firms to fire workers because of high levels of compensation that must be paid to the worker being laid off. It is argued that reducing workers' job security by making it easier and less costly for firms to let go workers has the effect of increasing employment, because firms are more likely to hire new workers if they know they can fire them easily and without cost if they are no longer needed. In addition, reducing job security would decrease firms' labour costs because of the lower costs of firing, and would therefore increase profits, investment and economic growth.

Incentive-related policies involve cutting various types of taxes, which are expected to change the incentives faced by taxpayers, whether firms or consumers, this includes; - lowering personal income taxes - lowering taxes on capital gains and interest income - lowering business taxes

As we know, the government can change personal income taxes as part of fiscal policy, thereby changing the level of aggregate demand. Supply-side economists argue that changes in personal income taxes have an even greater impact on aggregate supply. Cuts in personal income taxes lead to higher after-tax incomes, creating an incentive for people to provide more work: this can happen through an increase in the number of hours worked per week; an increase in the number of people interested in finding work (who were formerly not interested in working); an increase in the number of years worked, as people may decide to retire later; a decrease in unemployment as unemployed workers choose to shorten the duration of their unemployment. All these factors may work to shift the LRAS curve to the right, increasing potential output.

In many countries, people must pay taxes on 'capital gains', which are profits from financial investments (such as stocks and bonds) or from buying and selling real estate. In addition, they may have to pay taxes on income from interest on savings deposits. If the taxes they must pay on these sources of income are reduced, they may be more motivated to save, thus increasing the amount of savings available for investment. More investment means a greater production of capital goods and an increase in potential output.

Lower taxes on business profits can work to increase aggregate demand by increasing investment spending. Supply- side economists argue that cutting taxes on firms' profits is a supply-side measure because increases in the level of after-tax profits mean that firms have greater financial resources for investment and for pursuing technological innovations through more R&D. Both these effects give rise to greater potential output.

1. Time lags 2. Impact on economic growth 3. Ability to create employment 4. Ability to reduce inflationary pressure 5. Impact on the government budget 6. Effects on equity 7. Effects on the environment

Most supply-side policies, both interventionist and market-based, work after significant time lags, making their effects on the supply side of the economy (aggregate supply) over the longer term. This is because the activities set into motion (increased competition, labour market reforms, changing incentives, investments, new human and physical capital, R&D, and so on), need time to materialise and affect potential output. However, interventionist policies also have an effect on aggregate demand over the short term. Therefore, in a recession, such policies could have the added advantage that they can help close a recessionary gap. Yet, if an economy is experiencing inflation, they could contribute to destabilising the economy by adding to inflationary pressures.

Long-term economic growth is caused by investments in various forms of capital and new technologies, resulting in increased productivity of labour. In addition, economic growth is encouraged by the development of institutions involving incentives and the promotion of the market system and the freer working of supply and demand, allowing the private sector to work well. We have seen how a variety of supply-side policies seek to achieve these outcomes. Economists generally agree that supply-side policies play a very important role in increasing potential output.

Economists disagree on whether interventionist or market-based polices are more effective in increasing potential output. Supporters of interventionist policies argue in terms of the major advantages of targeted government support in areas such as investment, R&D, training and education, provision of credit on favourable terms (low interest rates, long repayment periods), and so on; they argue that the market is unlikely to provide them as needed. Moreover, industrial policies allow the government to support particular industries that are held to offer the greatest possibilities for growth in the future. They point to the experiences of a group of Asian countries which achieved very high rates of growth by use of highly interventionist policies focusing on investments in human capital and industrial policies. They also point to the questionable growth performance of many developing countries that adopted market-based supply-side policies in the 1980s.

Supporters of market-based policies argue that government interference in the market may lead to inefficiencies and resource misallocation, whereas reliance on the market can achieve long-term growth while avoiding these disadvantages. A major argument against government intervention and industrial policies involves the idea of government failure, according to which government interference may result in less efficient outcomes because of the influence of political pressures, lack of necessary information and unintended and unwanted consequences of government actions. It is argued that governments may lack the ability to choose the right industries to support, and incorrect choices will lead to a poor allocation of resources. In addition, supporters of market-based policies note that interventionist policies rely heavily on government spending, and use resources that might have better alternative uses elsewhere (opportunity costs). Governments require substantial amounts of tax revenues to be able to provide the support services, which means high taxes and a large government sector. High taxes act as disincentives to work, and a large government sector promotes inefficiencies.

Tax cuts (incentive-related policies) are among the more controversial market-based policies, because of their questionable effects on work, saving and growth of potential output. Tax cuts, as we know, have both demand-side and supply-side effects. Some economists question the strength of the supply-side effects, believing these to be small compared to the impact on aggregate demand. For example, increases in disposable income due to cuts in personal income taxes may result in the decision to work less if people prefer to use their extra (after-tax) income to increase their time for leisure. Also, workers may decide to use their higher after-tax income to consume more rather than save, in which case the tax cuts may not significantly affect saving and investment. In the United States, for example, whereas there have been a series of tax cuts, savings are at their lowest point in the past 80 years. In countries where tax cuts were implemented as supply-side policies (such as in the United Kingdom and the United States), economists disagree on whether or not these have worked to increase potential output. The reason is that whatever growth has occurred has been the result of both demand-side and supply-side effects of demand-side and supply-side policies, and it is very difficult to detect which particular policy has been responsible for each particular effect.

Interventionist policies involving investments in education and training can make a direct impact on a reduction of unemployment by: 1. enabling workers to acquire the skills, training and retraining necessary to meet the needs of employers (structural unemployment) 2. providing assistance to workers to relocate (structural unemployment) 3. providing information that reduces unemployment when workers are between jobs (frictional unemployment) or between seasons (seasonal unemployment). In addition, a focus on education and training of the general population can contribute to employment creation because better-educated and trained people are more employable.

Market-based policies involving labour market reforms may also contribute to reducing the natural rate of unemployment by focusing on making the labour market more responsive to supply and demand (lower wages and production costs, easier hiring and firing, etc.). Market-based policies that focus on encouraging competition, on the other hand, may well increase unemployment, at least over the short term. In the case of privatisation, as privatised firms try to make their operations more efficient, they often try to cut costs by firing workers. Contracting out to the private sector leads to government job losses, and job losses for the country as a whole if projects are contracted out to firms in other lower cost countries, as is sometimes the case. In addition, economic deregulation has frequently led to increased unemployment, due to increased competitive pressures that cause firms to fire workers in order to lower their costs. It is possible that increased unemployment on account of these policies may be short term, and may be reversed over the longer term as the economy begins to benefit from the broader effects of supply-side policies.

Supply-side policies, whether interventionist or market-based, are likely to reduce inflationary pressures over the longer term. The reason is that these policies are intended to increase potential output, shifting the LRAS curve to the right. As an economy grows, if increases in aggregate demand are matched by increases in aggregate supply, there will be little or no upward pressure on the price level. The ability of supply-side policies to reduce inflationary pressures can also be understood in terms of the focus on keeping firms' costs of production down through increases in efficiency (due to increased competition) and lower wage costs (due to increased labour market flexibility).

Interventionist policies and incentive-related market-based policies have negative effects on the government budget, though for entirely different reasons. Interventionist policies are heavily based on government spending, and therefore are a burden on the budget. Incentive-related policies involve tax cuts, and therefore reduced government revenues. Both these policies can create a budget deficit (or can increase the size of the deficit if there was one to begin with).

Interventionist policies that focus on investments in human capital that are broadly distributed throughout the population are likely to have positive effects on equity over the longer term. The reason is that educated, skilled and healthy workers are more likely to be employed and be an active and productive part of society, with the result that income is likely to be relatively more equally distributed. In addition, interventionist policies that lower the natural rate of unemployment reduce inequality by providing incomes to previously unemployed workers.

Market-based policies tend to have negative effects on equity. Greater competition may have a negative effect if it results in some unemployment, which involves a loss of income. Labour market reforms involve changes in legislation and institutions that provide protection for workers with very low incomes and with income uncertainties (minimum wage legislation, protection against being fired, unemployment benefits). Reducing protection results in lower incomes for some workers and increased job insecurity, and contributes to increasing income inequalities. Minimum wage legislation, for example, is intended to protect unskilled workers on very low incomes. Unemployment benefits and job security are especially important to people on very low incomes who have nothing to fall back on if they are left unemployed. In the case of incentive-related policies, tax cuts intended to create incentives to work, save and invest may also worsen income distribution. The argument that high taxes create disincentives to work and save applies mainly to higher income groups who face higher average tax rates; therefore, to reverse this problem, tax cuts must be designed to affect the after-tax incomes of higher income groups. Yet this would make the tax system less progressive, thus reducing the redistributive effects of personal income taxes and making income distribution less equal. In addition, since it is the wealthy who enjoy capital gains and earn most of the interest income and business profits, tax cuts in these areas will affect wealthy people by increasing their after- tax incomes more than they will affect lower income groups of the population.

It is possible that market-based policies to increase competition (privatisation, deregulation) may have negative effects on the environment because of the increased scope for activities leading to negative externalities affecting the environment. On the other hand, the government could limit these by taking the appropriate measures to correct or reduce the external costs of private sector activities.