Supply-Side Policy: Concepts, Tools, Advantages, and Disadvantages

What’s it: A supply-side policy is a type of economic policy in which the main focus is on aggregate supply. It seeks to increase the productivity, efficiency, and potential capacity of an economy.

These policies can involve policies such as government spending on education and research or reduce 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.

The difference between supply-side and demand-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. I’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. For the latter, it involves the sale or purchase of government securities by the central bank.

Expansionary monetary policy aims to increase the money supply, thereby stimulating economic growth. The central bank can take a combination of 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, the central bank can raise policy rates, increase the reserve requirement ratio, or sell government securities.

The advantages and disadvantages of supply-side policies over demand-side policies

Demand-side policies can stimulate economic growth, but with the consequence, inflation will also rise. For example, expansionary fiscal policy can stimulate higher economic growth and lower the unemployment rate. But on the other side, it would also result in higher inflation, 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 policies. With this policy, the government can increase the economy’s long-term productive capacity.

In the aggregate supply curve, as the productive capacity increases, you will see the long-run aggregate supply curve shifting to the right. That results 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.

Tools for supply-side policies

Basically, supply-side policies seek to increase the quantity and quality of factors of production. Among the possible efforts is to increase labor productivity and encourage 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. Deregulation is to reduce government power in a particular industry. But that doesn’t involve reducing government ownership, but rather through a series of regulatory easing.

Deregulation is to create more competition in the industry. Deregulation should also 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.

The productivity of workers increases and increases the potential output of the economy. Economies that have invested heavily in education are those who are prepared for the future. You can study the relationship between productivity and production through the Solow growth model.

Research and development

The government tries and encourages companies to invest in research and development by offering tax credits. 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. The reason is, by competing, companies will be encouraged to be better, 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.

Capital and labor input will be more productive with the application of better technology. 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 policies are critical in reducing the natural rate of unemployment. Natural unemployment is a type of unemployment that 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. That way, the production capacity in the economy rises 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 help 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 policies take longer, and their effects are more long-term. 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.