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What’s it? Supply-side policy is a type of economic policy that focuses on aggregate supply. It seeks to increase an economy’s productivity, efficiency, and potential capacity. Supply-side policies can involve government spending on education and research or reducing restrictive regulations.
Macroeconomic goals
In general, the main macroeconomic objectives of the government include:
- High and sustainable economic growth
- Low, stable inflation
- Full employment
- Equilibrium in the balance of payments
- Income distribution
Often these goals conflict with each other. Encouraging higher growth does reduce the unemployment rate. But on the other side, it will result in a higher inflation rate.
Demand-side policies vs. supply-side policies
Supply-side policies seek to influence the economy through aggregate supply. Meanwhile, demand-side policies affect the economy through aggregate demand.
Demand-side policies fall into two categories: fiscal policy and monetary policy. Meanwhile, supply-side policies can take various forms. We’ll cover that later. All right, let’s briefly discuss demand-side policies.
First, fiscal policy. The government influences the economy through its budget, namely taxes and expenditure budgets.
If it wants to stimulate economic growth, the government can implement expansionary fiscal policy. The options are by cutting tax rates or increasing spending.
Meanwhile, in contractionary fiscal policy, the government can raise taxes or reduce spending. By raising income tax, for example, households have to set aside more money to pay taxes. That reduces the part they can spend. That, in turn, reduces household consumption and lowers aggregate demand in the economy.
Second, monetary policy. This policy seeks to influence the economy through changes in the money supply. In this case, the central bank or monetary authority acts as a policymaker.
The three main monetary policy instruments are the policy rate, reserved requirements, and open market operations. The latter involves the central bank’s sale or purchase of government securities.
Expansionary monetary policy aims to increase the money supply, thereby stimulating economic growth. The central bank can do this by cutting interest rates, lowering the reserve requirement ratio, or purchasing government securities.
Meanwhile, when inflation is high, the central bank adopts a contractionary monetary policy. To do so, it can raise policy rates, increase the reserve requirement ratio, or sell government securities.
Market-based vs. Interventionist supply-side policy
Supply-side economics offers two main approaches to stimulating economic growth: market-based and interventionist. While both aim to increase production capacity, they differ in how they achieve this goal.
Market-based supply-side policy
Market-based supply-side policy champions minimal government interference. It relies on fostering an environment where market forces can thrive, including reducing unnecessary regulations that hinder business operations and adaptability.
Lowering taxes on businesses and individuals becomes another tool. Tax cuts incentivize investment, hiring, and innovation. Businesses have more resources to invest in new equipment and technology, while individuals have more disposable income to spend, boosting overall demand.
Additionally, market-based policy promotes trade liberalization. By removing barriers like tariffs and quotas, businesses gain access to cheaper inputs and a wider market for their products. Increased competition fosters efficiency and often leads to lower prices for consumers.
Finally, privatization, the transfer of state-owned enterprises to private ownership, can improve efficiency and drive innovation. Private companies, motivated by profit, often implement better management practices and cost-cutting measures.
Interventionist supply-side policy
Interventionist supply-side policy, on the other hand, takes a more hands-on approach. The government plays a more active role in stimulating economic growth. This can involve increased government spending on infrastructure, education, and research and development.
Investing in infrastructure creates jobs and improves transportation networks, while education and R&D programs lead to a more skilled workforce and technological advancements, all of which contribute to a more productive economy.
Additionally, the government can offer subsidies to specific industries or businesses, encouraging them to expand production or invest in new technologies. This can be particularly useful in promoting innovation or supporting strategic sectors of the economy.
Furthermore, the government can leverage its purchasing power through government procurement. By prioritizing the purchase of goods and services produced domestically or with specific technologies, the government can directly stimulate targeted industries.
Finally, investing in workforce development programs can significantly improve the skills and qualifications of the labor force, leading to increased overall productivity.
Benefits of supply-side policy
The supply-side policy aims to boost an economy’s potential from the inside out. Here’s a breakdown of the key benefits it aspires to achieve:
Economic growth without inflation
Demand-side policies can stimulate economic growth, but as a consequence, inflation will also rise. For example, expansionary fiscal policy can stimulate higher economic growth and lower the unemployment rate. However, it would also result in higher inflation, which is not in line with macroeconomic goals.
Likewise, the expansionary monetary policy aims to stimulate economic growth. For example, when interest rates fall, aggregate demand will increase and encourage more production. When the increase in production exceeds the capacity of the long-term economy. As a result, inflation will also be pushed up.
One way to encourage economic growth without causing inflation is through supply-side policy. With this policy, the government can increase the economy’s long-term productive capacity.
In the aggregate supply curve, as productive capacity increases, the long-run aggregate supply curve shifts to the right, resulting in a higher potential GDP.
Even though it produces high growth without causing inflation, supply-side policies are usually slow. It took longer to take effect.
Also, as in the Industrial Revolution, a potential increase in GDP is likely to result in downward pressure on aggregate prices. As a result, deflationary pressures are likely to arise in the short term due to a dramatic increase in productivity—what is known as the Great Deflation.
Improved long-term productivity
A core tenet of supply-side policy is to invest in the economy’s long-term productive capacity. This can involve funding education and training programs to equip workers with the skills businesses need to thrive in the modern economy.
Additionally, supporting research and development (R&D) can foster innovation and technological advancements. These investments empower businesses to produce more efficiently and create new products and services, ultimately boosting productivity over the long term.
Enhanced global competitiveness
In today’s globalized world, competitiveness is key. Supply-side policies that promote innovation, improve worker skills, and reduce unnecessary regulations can help domestic businesses compete more effectively in the international marketplace. This can lead to increased exports, a stronger trade balance, and a more resilient economy overall.
Tools for supply-side policies
Basically, supply-side policies seek to increase the quantity and quality of production factors. Possible efforts include increasing labor productivity and encouraging technological advances.
For example, improving an adequate education and training system provides workers with more skills. This can lead to higher labor productivity. In general, tools for supply-side policies include:
- Privatization
- Deregulation
- Aid for business
- Education and training
- Research and development
Privatization
The privatizations of various large industries (telecommunications, electricity, gas, etc.) were designed to break state monopolies and create more competition. So, conceptually, it is not only turning public sector monopolies into private sector monopolies but there is an attempt to introduce competition.
The private sector is for-profit. Private sector businesses will compete with each other to get a profit. When competition is more intense, they have to innovate to stay competitive.
Deregulation
Deregulation is similar to privatization. Its goal is to reduce government power in a particular industry. However, deregulation doesn’t involve reducing government ownership but rather a series of regulatory easing.
Deregulation aims to create more competition in the industry and ensure fair competition so as not to lead to private sector monopolies.
Aid for businesses
This form of assistance can be in the form of subsidies or grants. Other ways can take the form of reduced small business tax rates and tax breaks for investment.
The government gives it to businesses for several purposes. For example, the government provides it to encourage companies to engage in public research or to those who are innovative in developing technology.
Education and training
Some say that it is the most vital tool of all supply-side policies. Government spending on education and training improves human capital by improving skills and the quality of the workforce.
Workers’ productivity increases the economy’s potential output. Economies that have invested heavily in education are those that are prepared for the future. The Solow growth model can be used to study the relationship between productivity and production.
Research and development
The government offers tax credits to encourage companies to invest in research and development. If both are successful, this could allow the country to grow at a higher rate.
Economists are also of the view that encouraging fair competition will also lead to increased innovation, which results in faster technological progress. Innovation comes from reliable research and development.
Developed countries, such as the United States, prohibit practices that hinder fair competition. By competing, companies are encouraged to improve, resulting in many new innovations. This is why many technological innovations come from companies in developed countries, apart from educational factors and research quality, of course.
The application of better technology will increase the productivity of capital and labor input. Technological improvements allow the economy to produce more output using the same number of inputs. Using the latest, more sophisticated technology, workers can make more products than with conventional equipment beforehand.
Supply-side policies and unemployment rates
Supply-side policy is critical in reducing the natural rate of unemployment. Natural unemployment persists even though the economy is at full employment. It includes structural unemployment and frictional unemployment.
Supply-side policies are useful for reducing the natural rate of unemployment. One way is to encourage a more flexible labor market. For example, the government can make it easier to recruit and fire workers.
Another example is through improving education and training. It is for those who have just entered the labor force and those who are unemployed because their skills do not match market demand. For the latter, the government can seek reskilling, namely training new skills to do different jobs.
Supply-side policy advantages and disadvantages
The supply-side policy is the other side of economic policy. It aims to increase the quantity and quality of production factors, thereby raising the economy’s production capacity without sacrificing inflation.
Supports low inflation
To achieve low inflation, supply-side policies seek to increase output by increasing productivity. The firm produces more output from the same input.
Increased productivity reduces production costs. Thus, it reduces the likelihood for the producer to charge a higher selling price.
Bettering domestic products in international markets
Increased productivity also helps the balance of payments. If firms become more competitive, the demand for domestic goods will be higher. That, in turn, increased exports and reduced the pressure on the current account deficit.
An important supply-side policy for exporters is the quality of logistics, both in transportation and from supporting infrastructures such as roads, ports, and airports. Streamlining logistics flow and clearing supply bottlenecks can help reduce costs for businesses.
But, the policy takes longer.
Supply-side policy takes longer and have longer-term effects. For example, in education and training, human resources quality improvement will not necessarily show up in one or two years.
Moreover, there is no guarantee that government supply-side policies will actually reduce unemployment. For example, people may not want to join a training scheme.
Furthermore, if it is easier to hire and fire workers, there may be more temporary unemployment.
Finally, this policy does not solve the economic problem in the short run if the problem’s source is the aggregate demand side. During a recession, you won’t see the government forcing companies to increase their production. That would not solve the problem as household demand was weak at that time. So, even though output increases, no one wants to buy.
