AS Macro Revision: Supply-Side Policies

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Information about AS Macro Revision: Supply-Side Policies

Published on February 21, 2014

Author: tutor2u


AS Macro Revision Supply-Side Economic Policies Spring 2014

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Supply-Side Economic Policies They are policies that improve productive potential / capacity of an economy. Illustrated by an outward shift of LRAS (or of the PPF) • Supply-side policies focus on improving the structural performance of an economy • There are different approaches to supply-side reforms • Market-led policies – designed to make markets work better and give the private sector more freedom • State / government intervention in markets to overcome market failure • Supply-side reforms can affect both short run and long run aggregate supply – but the focus is usually on LRAS • The time lags involved with supply-side reforms can be long

Main Objectives of Supply-Side Policies Key concepts to focus on when discussing S-SPs are incentives, enterprise, technology, mobility, flexibility and efficiency 1. Improve incentives to look for work and invest in people’s skills 2. Increase labour and capital productivity 3. Increase occupational and geographical mobility of labour to help reduce the rate of unemployment 4. Increase investment and research and development spending 5. Promoting more competition and stimulate a faster pace of invention and innovation to improve competitiveness 6. Provide a strong platform for sustained non-inflationary growth 7. Encourage the start-up and expansion of new businesses / enterprises especially those with export potential 8. Improve the trend rate of growth of real GDP

The Difference between Production & Productivity It is important for student to make clear the distinction between production and productivity • Production • Value of output of goods and services e.g. measured by GDP or an index of production in specific industry • Productivity • A measure of the efficiency of factors of production • Measured by output per person employed • Or output per person hour • An increase in production DOES NOT automatically mean an increase in productivity – it depends on how many factors of production have been utilised to supply the extra output

Evidence for the UK Productivity Gap This describes relatively lower GDP per person employed or per hour worked in the UK compared to other countries Index of GDP per hour worked (UK = 100) France Germany Italy UK USA 2000 120 117 110 100 121 2007 119 119 99 100 121 2010 123 121 103 100 129 2012 124 124 103 100 129 Note: This table should be read horizontally Source: OECD, Office for National Statistics

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If Supply Side Policies Work In general, a stronger supply-side performance allows a government to meet more of the key macro objectives 1. Achieve a sustained improvement in the possible trade-off between inflation and unemployment (see Phillips Curve) 2. Be more flexible in response to external demand and supply-side shocks such as rising energy prices 3. Raise living standards through stronger long term economic growth / an increase in underlying trend rate of growth 4. Reduce unemployment by lowering the natural rate of unemployment (less frictional & structural unemployment) 5. Improve competitiveness in global markets and achieve a stronger balance of trade in goods and services

Showing Long Run Economic Growth using AD-AS General Price Level LAS1 LAS2 AS1 AS2 AD1 AD2 GPL1 Y1 An increase in a country’s productive potential causes an outward shift of LAS. Short run supply increases because of lower unit costs An increase in productive potential allows an economy to operate at a higher level of AD Yp1 Y2 Yp2 Real GDP

Key Supply-Side Challenges for the UK Economy Productivity Gap High youth unemployment Low trend growth of GDP Rise of Emerging Nations Deep regional economic divide Structural trade deficit (BoP) Low investment & research Rising inequality / relative poverty

Pro-Market (Private Sector) Supply-Side Policies These focus on reducing the size of the state and in boosting the role of market forces in allocating scarce resources • Cutting government spending and borrowing • Lower business taxes to stimulate investment • Lower income taxes to improve work incentives • Reducing red-tape to cut the costs of doing business • Measures to improve the flexibility of the labour market / reforming employment laws • Policies to boost competition - deregulation and anti-cartel laws • Privatisation of state assets • Opening up an economy to overseas trade and investment • Opening up an economy to inward labour migration

Examples of UK Government Supply-Side Policies Privatisation of Royal Mail Patent Box Incentive Shale Gas Tax Cuts Corporation Tax Cuts Modern Apprenticeships Welfare Caps / Reforms Infrastructure Plan Launch of Green Investment Bank

State / Government Intervention Supply-Side Policies Supporters of these policies argue that an interventionist state can have a powerful long-term effect on supply-side performance • State investment in public services and critical infrastructure • A commitment to a minimum wage and/or living wage to improve work incentives in the labour market • Higher taxes on the wealthy to fund public and merit goods • Active regional policy to boost under-performing areas / areas of persistently high unemployment • Selective import controls to allow domestic industries to expand • Management of the exchange rate to improve competitiveness • Nationalisation of and/or stronger regulation of industries

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The Growth of Productive Potential – Trend Growth

Economic Advantages of Higher Productivity 1. Lower unit costs: Cost savings for businesses can bring lower prices, encouraging higher demand, more output and an increase in employment 2. Improved competitiveness and trade performance (BoP) 3. Higher profits: Efficiency gains are a source of larger profits for companies which might be re-invested 4. Higher wages: Businesses can afford higher wages when their workers are more efficient 5. Economic growth: If an economy can raise productivity then the trend growth of national output can pick up 6. Productivity improvements mean that labour can be released from one industry and be made available for another

Research and Development (R&D) R&D is focussed on the creation and improvement of products and processes, based on scientific research – applied to market needs • Spending on R&D in the UK has been <2% of GDP for many years • The biggest barriers to innovation are • Risk aversion – research is expensive, rewards are uncertain • Uncertainty about ability to exploit research and make a profit • A lack of high-skilled workers • Top EU companies: Nokia, Volkswagen, Bosch and Siemens • The top UK firms are GlaxoSmithKline and AstraZeneca • The level of research spending is not necessarily a guide to the pace and success of innovation. Many businesses do not patent all their most innovative ideas but keep them as trade secrets

Selected Competitiveness Rankings for 2013 1: Switzerland 4: Germany 2: Singapore 5: United States 3: Finland 10: UK Competitiveness Indicators 1. Institutions and Infrastructure 2. Macroeconomic stability 3. Health/education systems 4. Financial markets (including strength/stability of banks) 5. Technological readiness 6. Market size (linked to population size and per capita incomes) 7. Business sophistication (quality of supply chains, industrial clusters) and rate of innovation

Innovation Innovation is putting a new idea or approach into action. Innovation is 'the commercially successful exploitation of ideas' • Product innovation • Small-scale, frequent subtle changes to the characteristics and performance of a good or a service • Process innovation • Changes to the way in which production takes place or is organised • Innovation has demand and supply-side effects in markets and the economy as a whole Austrian economist Joseph Schumpeter coined the term creative destruction which refers to the complete upheaval of the established order in the pursuit of innovation.

International (External) Competitiveness External competitiveness is the ability to sell goods and services at competitive prices in a foreign country • Cost competitiveness – differences in unit costs between producers – reflected in prices • Non-price competitiveness – product quality, design, reliability and performance, choice, aftersales services, marketing, branding and the availability and cost of replacement parts • Non-wage costs: • Costs of meeting environmental / health regulations • Environmental taxes e.g. carbon taxes and waste taxes • Employment protection laws and health and safety laws • Requirements to provide pensions for employees

Policies to Improve International Competitiveness Improving Labour Markets • Investment in education , management • Encouraging inward migration of skilled workers Infrastructure Investment • Better motorways, ports, hi-speed rail • Communications e.g. super-fast broadband, 4G Supporting Enterprise / Entrepreneurship • Improved access to business finance • Incentives for innovation and invention Macroeconomic Stability • Maintaining low inflation / price stability • A sustainable banking system

Evaluating the Impact of Supply-Side Policies Supply-side policies can have a powerful effect on economic performance – but be aware of limitations and disadvantages 1. Supply-side policies have long time lags – especially when they are trying to achieve structural changes 2. The level of aggregate demand is also important in making business investment and innovation viable 3. Some supply-side policies (e.g. cutting higher-rate income taxes) might lead to greater inequalities of income & wealth 4. State intervention to “pick winners” in different industries may be ineffective – there are risks of government failure 5. Sustainability issues if policies aim to raise a country’s long term growth rate – leading to increased externalities such as pollution 6. Supply-side policies look to achieve relative improvements e.g. In productivity – but other countries will be making gains too

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