Explain how governments can use supply side policies to facilitate economic growth. Use examples to support your answer.
Discuss how governments can use fiscal and monetary policy to temporarily stimulate economic growth.
Role of the Government is to ensure prosperity of the nation and wellbeing of its citizens. Effective governance and economic policies are key to ensure prosperity of the nation. Government’s one of the main economic objectives is to ensure economic growth for the benefit of the people or citizens. In order to facilitate such an objective, government can pursue a variety of policy tools. Main tools include use of fiscal (demand and supply side policies) and monetary policy to facilitate economic growth. This paper explains how governments can use supply side policies to facilitate economic growth. In addition, it also discusses the ways governments can use fiscal and monetary policy to temporarily stimulate economic growth.
The meaning of supply-side policy is related to any policy, which is valuable to get better the productive potential and ability of an economy to produce (Higson, 2011). To fulfil the aim of facilitating the economic growth, the government can use supply-side policies. In this, the government can reduce taxation through supply-side policy and encourage entrepreneurship together with stimulation of investment in human capital (Baimbridge, Whyman, and Burkitt, 2012). It is found normally “aggregate supply curve normally moves in the right direction due to the use of supply side policies consequently resulting in more output at lower prices, until the period when economy is not having the full employment level” (Cook and Healey, 2001).
Also it can be seen that, defined supply side policies as “the government policies that are intended to stimulate the growth of an economy, the rate at which the LRAS curve is shifted to the right” (Anderton, 2000). In the below figure, output increases to OB from OA due to the shift of LRAS curve to the right.
Figure 1: Supply side Policies
(Source: Anderton, 2000).
Additionally, the government of the country can go about making several decisions that will improve supply-side performance in the economy. For instance, the government can make the necessary changes in the tax structure in the country to provide benefits to help stimulate factor output instead of changing demand. This is one of the key aspects of making supply-side policy. For example, the government can reduce direct tax rates such as corporation and income tax. In this, lower corporation tax will provide an incentive to new enterprisers to commence and consequently boost national output (Higson, 2011). At the same time, for unemployed workers, if they have to pay less income tax; this will work as an incentive for them to work in the labour market as well as motivating the currently employed workers to put more efforts and give more output (Cook and Healey, 2001).
In addition, the government can also use other supply side policies such as by pushing more competition in labour markets through labour market rigidities, and removal of restrictive practices including the employment protection to facilitate the economic growth (Higson, 2011). For example, in the 1980s, one of the key supply side reforms that was introduced is that significant powers that trade union earlier had were reduced through several measures including implementing secret ballots for union members before they could go on a strike and thus limiting their ability to go on strike (Higson, 2011).
In addition, supply side policy can also include initiatives to improve labour mobility that also leads to having a positive impact on the productivity of the labour and on supply-side performance (Higson, 2011). At the same time, it is also found that the use of liberal supply-side policies can be the effective way to stimulate the economic growth (Woodward, 2004).
Concurrently, in order to facilitate economic growth through the use of supply side policies, spending on training and education is one of the important supply side options. It is because it is beneficial to improve labour productivity resulting in facilitating economic growth. It is also a favoured option by recent UK government. Building of better training and education programs to get better skills, mobility, and flexibility is also called human capital development (Higson, 2011). A government can directly spend money or offer incentive for private suppliers to penetrate in the market. At the same time, government, can also force schools to include a skill part in their program, and set and monitor standards of teaching (Higson, 2011).
Moreover, the government can also adopt performance related pay in the public sector to contribute in improving whole productivity. Additionally, government can also encourage local rather than central pay bargaining to facilitate economic growth through the use of supply side policies (Higson, 2011). It is because national pay rate rarely shows local conditions and reduce mobility of labour. In addition, the use of different rates would be helpful to allow the labour to move in the sector, where it is demanded largely.
In addition to the above supply-side policies, there are also other supply-side economic frameworks that emphasize on growth and employment, which can support the government to channel credit. In this, “investment tax credit, high marginal tax rates on uninvested profits coupled with general investment reserves, and other incentives for saving complement” are some other tools and frameworks for controlling the factors related to the supply that can be used by the government for fostering growth and employment.
There are also other supply side policies such as deregulation, privatisation, providing better information, lower tariff barriers, deregulate financial and labour market and improving transport and infrastructure that can be used to facilitate economic growth. Thus, it can be stated that all these policies can be used by the government in order to foster economic development in the country by improving current as well as potential productivity level.
Use of Fiscal Policy:
In order to stimulate the economic growth, fiscal and monetary policies are important and can be used by the government for temporarily stimulating economic growth. Fiscal policy refers to the policy, which affects total demand by shifting the government’s outflow (expenditure) and inflow (taxation) (Sloman, Norris, and Garrett, 2013). Additionally, fiscal policy denotes to taxes, government purchases, borrowings and transfer payments as these significantly affect different macroeconomic variables including employment, GDP, economic growth, and the price level.
It shows that fiscal policy deals with the changes in the composition and the level of government spending related to sectors (education, welfare, healthcare, and infrastructure) subsidies and taxation (Robinson, Symonds, Gilbertson, and Ilozor, 2015). For example, to resolve the credit crunch problem in the UK, the government adopted fiscal policies leading to an aspirational plan for deficit reduction, cutting government expenditures affecting investment by public sector and its building activities with the purpose to stimulate the economic growth (Robinson, Symonds, Gilbertson, and Ilozor, 2015). Another example include the implementation of a series of tax cuts by the federal government in the year 2008 to stimulate sales and growth resulting in stimulating economic growth (Cohen, 2012).
Additionally, in order to stimulate economic growth, the government can use its tax instruments and expenditures. Expansionary fiscal policy and contractionary fiscal policy are the two main policies that can be used by the government to temporarily stimulate economic growth. As a part of expansionary fiscal policy, the government can cut taxes and raise government expenditures for the purpose to stimulate the economic growth. The use of expansionary fiscal policy can be effective to stimulate the economy and enhance total employment for a short-time period. In contrary, in the long-run due to the cost-reduction behaviour via the collection of human capital, the growth ultimately becomes unsustainable (Otaki, 2015). In contrast, through contractionary fiscal policy the government can raise taxes and reduce government expenditure to stimulate the economic growth (Arnold, 2008).
The below graph shows the shifts in supply and demand or manipulation inflation or growth due to the use of expansionary and contractionary fiscal policy.
Figure 2: Shift in Demand and Supply: Manipulating Inflation and Growth
(Source: Henderson, 2004).
It is clear from the above graph that the use of expansionary fiscal or monetary policy shifts out the demand curve, increasing price and output (P2 and Y2), due to reduction in tax and increase in government expenditures. In contrast, due to reduction in government expenditures and increase in taxes, the supply curve push back, increasing prices and contracting output (P1 and Y1) (Henderson, 2004).
At the same time, the government can also use fiscal policy tools to induce economic growth. Fiscal policy tools can be broadly categorized in two ways namely automatic stabilizers and discretionary fiscal policy. Automatic stabilizers refers to the spending and revenue initiatives in the federal budget that adjust automatically with the ups and downs of the economy to stabilize disposable income and consequently real GDP and consumption (McEachern, 2008). For example, the federal income tax acts as an automatic stabilizer since upon implementation of this, there is no need for any congressional action to activate and secondly, it reduces the jump in income available for spending or saving during expansions and also reduce the drop in disposable income during recessions.
On the other hand, discretionary fiscal policy involves the considerable manipulation of the purchase by government, taxes and transfer payments, to support macroeconomic goals related to price steadiness, full employment, and stimulate the economic growth (McEachern, 2008). The examples of discretionary fiscal policies include tax cuts by the president Bush in his tenure in America.
In order to stimulate the economic growth, the government can also adjust the level of aggregate demand and aggregate supply (McEachern, 2011). In this, through the use of stabilisation policy, the government can adjust the level of aggregate demand with the purpose to remove any severe inflationary or deflationary gaps and smooth out business cycle related fluctuations in the economy (Sloman, Norris, and Garrett, 2013). In contrast, the government also affects the aggregate supply through the use of fiscal policy. For example, increase in expenditures on infrastructure and given of tax incentives by the government for investment.
Aggregate demand refers to “the relationship between the total spending in an economy on domestic goods and services and the price level of output” (Textbook Equity Edition, 2014). Thus, the total expenditure on domestic goods is depicted by the aggregate demand curve and it shows the total expenditure on domestic goods and services at each price level.
Figure 3: Aggregate Demand Curve
(Source: Textbook Equity Edition, 2014).
In the above graph, the horizontal axis presents to the real GDP and the vertical axis shows the price level. The graph also indicates that AD curve slopes down, which means that a lower quantity of total spending results in due to the raise in the price index of outputs (Textbook Equity Edition, 2014). Additionally, this shape is also found due to the impact of changes in the prices level on different components of collective demand such as spending on consumption, investment spending, government expenditure, spending on exports, and minus imports (Textbook Equity Edition, 2014). In contrast to AD curve, the AS curve slopes upward.
The government can also apply the equilibrium in the aggregate supply and aggregate demand model to stimulate the economic growth (See the below graph). In this, to stimulate the economic growth, the government can ensure the real GDP equilibrium and the price level equilibrium in the economy (Textbook Equity Edition, 2014).
Figure 4: Equilibrium in the aggregate supply and aggregate demand model
(Source: Textbook Equity Edition, 2014).
In the above graph, the equilibrium point occurs at point F, at a price level of 90 and an output level of 8800. Comparatively at a low price level for output, companies have short benefits to produce, but concurrently, consumers are enthusiastic to purchase more good. But, as the price level increases for output, total supply rises and total demand falls until the equilibrium point is reached (Textbook Equity Edition, 2014).
In contrast to fiscal policy, monetary policy refers to the actions that are aimed to influence the availability of money and its cost in the market (Morton, and Goodman, 2003). Monetary policy’s primary objective is to ensure the monetary stability and to stimulate economic growth (Lee, 1990). In simple words, it can be stated that the aim of monetary policy is to keep real economic growth equals to with the likely economic growth as determined by resources, technology, and environment, etc (Peng, 2015). It is because if the economy’s real growth rate is greater than the potential growth rate, it causes inflation that can have adverse impact on the economy. Bank rates, interest rates and open market purchases are some tools under monetary policy that can be used to stimulate the economic growth by controlling the supply of the money in the economy (Bishop, 2012).
Concurrently, to induce economic growth, monetary policy deals with broad combines of money supply, the rates of interest and liquidity. These factors are important for debt management. For example, in the UK during the credit crunch, the monetary policy adopted includes “lowering interest rates to an all time low and quantitative easing” to enable business to expand by creating situation where businesses can avail loans easily at lower interest rates (Robinson, Symonds, Gilbertson, and Ilozor, 2015).
Additionally, in order to stimulate “sluggish” economies, it is likely from monetary authorities to cut interest rates and increase the supply of money (Hudson, 2010). Thus, these tools can be adopted by the government, to temporarily stimulate economic growth. But, at the same time, it is assessed that in the situation, when an economy has grown beyond optimal scale or beyond maximum sustainable scale, the use of monetary policy to induce the growth of an economy can have more negative impacts on the society than good (Hudson, 2010). It is found that in such situation, the use of tighter money supplies and higher interest rate are appropriate. In contrast, only when there is inflation threatens, monetary authorities favour restrictive money supplies and higher interest rates.
Many economists also understand that there has limited effects of the use of monetary policy. It is because it can create the situation of high inflation in the country. In contrast, the use of supply side policies by the government are effective that “inflation does not become a problem as these are very helpful to provide a growth in aggregate supply that leads to the condition where it is equal to growth in aggregate demand” (Anderton, 2000). It is found that although monetary policy as “pull out all the stops” is designed to stimulate the economic growth, however fiscal policy too is designed for growth (Hudson, 2010). In this, taxes are reduced with the purpose that consumers will then expend more and induce the economy. Similarly, reallocation of budgets is also designed in a manner to stimulate the economy.
Additionally, as a part of monetary policy, the government can also reduce the federal funds rate to stimulate the economic growth. For example, the growth of the US economy in the year 2001 was declined by 2.1%. In order to enable economy recovery and to stimulate growth, “the US central bank has taken steps to reduce the federal funds rate many times (11) within the same year” (Hudson, 2010). Another method that the government can use as a part of monetary policy to stimulate the economic growth is quantitative easing. This method could be adopted at the time, when the interest rate could not be lowered further. In quantitative easing method, the government can purchase significantly huge quantity of different kinds of assets that will lead increase in the supply of money. For example, in the world, Central Bank of Japan was the first to use the monetary policy of quantitative easing including purchase of stock and treasury bills (Hudson, 2010). There are also other methods such as lowered deposits and loan rates and expanded money supply or use of expansionary monetary policy that were adopted in China after 1997 for stimulating economic growth.
Moreover, in order to make a stable macroeconomic environment, the use of monetary policy can also be beneficial by keeping inflation low and improving the decision-makers confidence as well as encourage firms to invest in order to generate an increase in production capacity (Smith, 2015). It can also be beneficial to stimulate the economic growth and create an opportunity to improve living standards. The below is the AD/AS graph which is drawn in terms of the overall price level (Smith, 2015).
Figure 5: AD/AS Graph
(Source: Smith, 2015).
As per the graph, the initial equilibrium is with real output at Y0, the rate of interest at r0, and the price level at P0. In order to maintain money market equilibrium , with an increase in the rate of interest to r1, it is essential to balance it with the decrease in money supply. It will have also a significant impact on the investment, which is presented in the middle panel of the figure. It is clear from the above graph that a fall in investment from I0 to I1 will result in due to the increase in the interest rate. Additionally, this will shift the aggregate demand curve from AD0 to AD1 that leads to decrease in real output level at Y1 and reduced overall price level P1 (Smith, 2015).
Overall, it can be stated that the government can use monetary policy in terms of lowering interest rate, federal reserve rate, loan rate and quantitative easing techniques to stimulate the economic growth
Conclusion
Based on the above discussion, it can be stated that the use of different supply side policies is effective to facilitate economic growth by improving current and potential productivity level. In this policy framework, the government can reduce taxation through supply-side policy and encourage entrepreneurship together with stimulation of investment in human capital. Further, spending on training and education is one of the important supply side options.
It can also be stated that to stimulate economic growth, the use of monetary and fiscal policy is also effective. In UK, the monetary policy that is being followed is in lowering interest rates and quantitative easing that helps the growth in business to enlarge by creating situations that lead to loans for organisations at lower interest rates. Fiscal policy stimulates economic growth by altering taxation and government expenditures while monetary policy induces economic growth by controlling money supply.
References
Anderton, A. (2000) Economics. USA: Pearson Education Inc.
Arnold, R. A. (2008) Macroeconomics. USA: Cengage Learning.
Baimbridge, M., Whyman, P. B., and Burkitt, B. (2012) Moored to the Continent: Future Options for Britain and the EU. UK: Andrews UK Limited.
Bishop, T. (2012) Money, Banking and Monetary Policy. USA: Lulu.com.
Brady, D. and Keister, L. A. (2011) Comparing European Workers: Part B: Policies and Institutions: Policies and Institutions. UK: Emerald Group Publishing.
Cohen, M. A. (2012) The Global Economic Crisis in Latin America: Impacts and Responses. UK: Routledge.
Cook, M. and Healey, N. (2001) Supply Side Policies. UK: Heinemann.
Henderson, T. M. (2004) Fixed Income Strategy: A Practitioner’s Guide to Riding the Curve. USA: John Wiley & Sons.
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Hudson, R. J. (2010) Animal and Plant Productivity. EOLSS Publications.
Lee, S. Y. (1990) The Monetary and Banking Development of Singapore and Malaysia. NUS Press.
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Otaki, M. (2015) Keynesian Economics and Price Theory: Re-orientation of a Theory of Monetary Economy. Germany: Springer.
Peng, X. (2015) Financial Theory: Perspectives from China. USA: World Scientific.
Robinson, H., Symonds, B., Gilbertson, B. and Ilozor, B. (2015) Design Economics for the Built Environment: Impact of Sustainability on Project Evaluation. USA: John Wiley & Sons.
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