Supply Side Policies are policies aimed at increasing Aggregate Supply (AS), a shift from left to right. They enhance the productive capacities of an economy while improving the quality and quantity of the four factors of production. However, supply side policies are difficult to implement and take time to take effect.
Successful policies lower the natural rate of unemployment. Economists also believe that successful supply side policies can contribute to long-term economic growth without increasing the rate of inflation.
Reaganomics espoused many supply side policies.
Examples of Supply Side Policies
1. Labor Market
Lowering wages frees up the labor market, which makes a lower paid job more attractive. To lower wages, the government would need to do things like abolishing minimum wage laws, decentralizing trade union power, reducing of unemployment benefits, lowering income tax and make hiring/firing easier and cheaper for firms. However, these policies are very politically unpopular and aren’t likely to be implemented.
2. Capital Markets
The government needs to create money for banks to lend for investment. The government can do this by increasing competition between banks to make loans more attractive, reducing financial crowding out and by making savings more attractive.
The government needs to encourage entrepreneurs to start new businesses by lowering the marginal tax rate and encouraging share ownership amongst employees. Another commonly used policy is not requiring new businesses to pay corporate taxes during their first three years or if they don’t cross a minimum revenue during the initial years.
4. Competition and Efficiency
The government will need to increase competition between firms and increase the overall efficiency of the economy. They could do this through the removal of monopolies, by privatizing certain industries, freeing up trade (through the reduction or elimination of trade barriers) and by implementing inward investment policies.
Better education and training to improve skills will improve labor productivity.
Impact of Successful Supply Side Policies
In the diagram below, we can see a shift in Aggregate Supply from S1 to S2, which shows the impact of a successful supply side policy.
1. Lower Inflation
Shifting Aggregate Supply to the right will result in a lower price level. By making the economy more efficient, supply-side policies help reduce cost push inflation.
2. Lower Unemployment
Supply-side policies can help reduce structural, frictional and real wage unemployment and therefore help reduce the natural rate of unemployment.
3. Improved economic growth
Supply-side policies can increase the sustainable rate of economic growth by increasing Aggregate Supply.
4. Improved trade and Balance of Payments
By making firms more productive and competitive, firms are able to export more goods and services.
Long Run Effects of Supply-Side Policies
In the short run, Supply Side Policies will affect the Short-Run Aggregate Supply (SRAS). They will cause a shift from SRAS1 to SRAS2 (an increase in Aggregate Supply). While in the long run, this will result in an increase in Aggregate Supply from LRAS1 to LRAS2.
Production Possibility Curve with a Successful Supply Side Policy
In terms of a production possibility curve, it would shift capabilities from ‘A’ to ‘B.’ A Production Possibility Curve represents a country’s available resources and the maximum two goods produced from those resources.
Disadvantages of Supply Side Policies
1. Time Lag
Most supply-side policies can take a long time to work and for the effects to be seen in the economy. For example, if the country wants to improve the quality of human capital, through education and training, this will normally take years to complete and for the economy to reap tangible benefits.
Supply Side policies can be costly to implement. For example, for the government to improve the quality of human capital, it will need to sponsor or subsidize education and training programs. These programs are highly labor intensive and extremely costly.
Many supply side policies are politically unpopular and therefore unlikely to be implemented. For example, unions wield significant political influence and would oppose any negative labor market changes like breaking up unions or abolishing minimum wages.