Economics is an important part of any business organization, regardless of the industry that it may be a part of. Over the years numerous changes have happened in terms of economic aspect of operating and managing a business, but never the less, its importance has not declined by any manner (Baye and Beil, 2009). The present report focuses on explaining ways in which governments use supply side policies to facilitate and promote economic growth in their countries. Furthermore it also explains why and how governments and other such institutions use fiscal and monetary policies to slow down economic activities thus stunting growth and development in the country.
Using supply side policies to facilitate economic growth
Supply Side economics is the branch of economics that considers how to improve the productive capacity of the economy. It tends to be associated with Monetarist, free market economics (Kirchhoff, 2014). These economists tend to emphasize the benefits of making markets, such as labour markets more flexible. However, some supply side policies can involve government intervention to overcome market failure. It includes any policy that improves an economy’s productive potential and its ability to produce. There are several individual actions that a government takes to improve supply-side performance.
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Individual actions that government(s) can take in context of supply side policies can be divided into two categories :
Iimproving productivity of factors
There are certain ways to enhance productivity of factors. Herein tax system can be used to provide incentives to stimulate factor output, instead of changing the demand. This aspect is considered a very basic part of supply side policies (Harzing and Wal, 2009). Tax system can used by reducing tax rates including income tax and corporation tax. Lower income tax will act as an incentive for unemployed workers to join the labor market, or for existing workers to work harder. Lower corporation tax provides an incentive for entrepreneurs to start and so increase national output. Other supply-side policies include the promotion of greater competition in labor markets, through the removal of restrictive practices, and labor market rigidities, such as the protection of employment. Measures to improve labor mobility will also have a positive effect on labor productivity, and on supply-side performance (Cadsby and Maynes, 2008). This improves labor market flexibility. Better education and training to improve skills, flexibility, and mobility – also called human capital development. Spending on education and training is likely to improve labor productivity and is an essential supply-side policy option, and one favored by recent UK governments. A government may spend money directly, or provide incentives for private suppliers to enter the market. Government may also set and monitor standards of teaching, and force schools to include a skills component in their curriculum. The adoption of performance-related pay in the public sector is also seen as an option for government to help improve overall productivity (Mittelhammer and Mittelhammer, 2007). Government can encourage local rather than central pay bargaining. National pay rates rarely reflect local conditions, and reduce labor mobility. For example, national pay rates for Postmen do not reflect the fact that in some areas they may be in short supply, while in other areas there may be surpluses. Having different rates would enable labor to move to where it is needed most.
Improving performance of firms
In order to improve performance of firms, government(s) use supply side policies by paying attention to aspects like competition, efficiency, global market trends (Williamson, 2010). Government may help to improve supply-side performance by giving assistance to firms to encourage them to use new technology, and innovate. This can be done through grants, or through the tax system. Deregulation of product markets may be implemented to bring down barriers to entry, encourage new and dynamic market entrants, and improve overall supply-side performance. The effect of this would be to make markets more competitive and increase efficiency (Cherchye and Abeele, 2015). Promoting competition is called competition policy. Privatization of state industry was a central part of supply-side policy during the 1980s and 1990s, and helped contribute to the spread of an enterprise culture. As long as privatization is accompanied by measures to promote competition, there are likely to be efficiency gains for the firm, and productivity gains for the employees. Supply side performance can also be improved if there is a constant supply of new firms. Small businesses are often innovative and flexible, and can be helped in a number of ways, including start-up loans and tax breaks (Hanson, 2012).
Numerous benefits are associated with the use of supply side policies by government(s). Some of them are enumerated as follows:
Lower inflation rate: Supply-side policies can help reduce inflationary pressure in the long term because of efficiency and productivity gains in the product and labor markets.
Improve trade and balance of payments: These can also help create real jobs and sustainable growth through their positive effect on labor productivity and competitiveness (Antonides, 2011). Increases in competitiveness will also help improve the balance of payments.
Less likely to create conflicts: Supply-side policy is less likely to create conflicts between the main objectives of stable prices, sustainable growth, full employment and a balance of payments. This can be proved through fact that supply side policies have been extensively popular over the last many years (Jacques and Nigro, 2007). They have helped government(s) to improve financial performance and economic standing of their country in the world market.
But on the other hand, there are certain side effects or disadvantages associated with use of supply side policies to facilitate economic performance. Supply-side policy can take a long time to work its way through the economy. For example, improving the quality of human capital, through education and training, is unlikely to yield quick results (Cohen and Klepper, 2012). The benefits of deregulation can only be seen after new firms have entered the market, and this may take a long time. In addition, supply-side policy is very costly to implement. For example, the provision of education and training is highly labor intensive and extremely costly, certainly in comparison with changes in interest rates. Furthermore, some specific types of supply-side policy may be strongly resisted as they may reduce the power of various interest groups. For example, in product markets, profits may suffer because of competition policy, and in labor markets the interests of trade unions may be threatened by labor market reforms (Rhoades, 2015). Finally, there is the issue of equity. Many supply-side measures have a negative effect on the distribution of income, at least in the short-term. For example, lower taxes rates, reduced union power, and privatization have all contributed to a widening of the gap between rich and poor.
Some of the supply side policies used by UK government during time of 1980s to 1990s are as follows:
Privatization: There has been an extensive privatisation campaign, most of the major utilities such as Gas, Water and Electricity were sold by the government and floated on the stock market. In some industries like telecommunications it has led to more competition, lower prices and better quality of service (Berger and Hannan, 2008). However it has been difficult to introduce competition into the water industry. Rail Privatisation has been unsuccessful with the government having to effectively renationalise the railways.
Income tax cuts: In the 1980s income tax was cut especially for the better off. The top rate of income tax fell from 60% to 40%. Overall the tax burden has not fallen because the government has increase indirect taxes such as VAT (Millmow, 2009).
Reduced power of trade unions: The power of trades unions has fallen because of laws making it more difficult for unions to operate. As well as supply side policies, the decline of manufacturing industries reduced the influence of trades in many industries like coal and steel. There are now less days lost to strikes and wage inflation has not been a problem like in the 1970s (Chronis and Strantzalou, 2008). But still many workers are less protected and may get lower wages leading to greater inequality.
Deregulated financial markets: The government has deregulated the financial services market, for example building societies can act like banks, and more institutions can now offer mortgages, this led to more competition and lower borrowing costs. However, the credit crunch of 2008-09, illustrated the problem of less regulated financial markets.
Fig 1: Supply Side Policies used by UK government
Increase is productivity is not just a result of the supply side policies, rather it is an amalgamation of many more factors and aspects. For instance, development of better technology has helped companies to enhance their performance and as a result economic productivity of the country has improved substantially (Leigh, 2015). Development of the internet has helped reduce costs for firms and increase competition, this is not due to the govt. Lower prices of raw materials is another such factor. In the past decade the price of raw commodities have stayed low, this has helped keep inflation low. Additionally, foreign companies have often been successful in implementing better working conditions (Johnsen and Melicher, 2014).
How government can use fiscal and monetary policy to temporarily slow economies
There are two powerful tools that government and the Federal Reserve use to steer economy in the right direction: fiscal and monetary policy. When used correctly, they can have similar results in both stimulating economy and slowing it down when it heats up. The ongoing debate is which one is more effective in the long and short run.
Fiscal policy is when government uses its spending and taxing powers to have an impact on the economy (Kirchhoff, 2014). The combination and interaction of government expenditures and revenue collection is a delicate balance that requires good timing and a little bit of luck to get it right. The direct and indirect effects of fiscal policy can influence personal spending, capital expenditure, exchange rates, deficit levels and even interest rates, which are usually associated with monetary policy (Jacques and Nigro, 2007).
Fiscal policy is often linked with Keynesianism, which derives its name from British economist John Maynard Keynes. His major work, "The General Theory Of Employment, Interest And Money," influenced new theories about how the economy works, and is still studied today. He developed most of his theories during the Great Depression and Keynesian theories have been used and misused over time, as they are a popular and are specifically applied to mitigate economic downturns (Rhoades, 2015). In a nutshell, Keynesian economic theories are based on the belief that proactive actions from government are the only way to steer the economy. This implies that the government should use its powers to increase aggregate demand by increasing spending and creating an easy money environment, which should stimulate the economy by creating jobs and ultimately increasing prosperity. The Keynesian theorist movement suggests that monetary policy on its own has its limitations in resolving financial crises, thus creating the Keynesian versus the Monetarists debate (Johnsen and Melicher, 2014).
Just like monetary policy, fiscal policy can be used to influence both expansion and contraction of GDP as a measure of economic growth. When the government is exercising its powers by lowering taxes and increasing their expenditures, they are practicing expansionary fiscal policy. While on the surface, expansionary efforts may seem to lead to only positive effects by stimulating the economy, there is a domino effect that is much broader reaching (Mittelhammer and Mittelhammer, 2007). When the government is spending at a pace faster than tax revenues can be collected, the government can accumulate excess debt as it issues interest bearing bonds to finance the spending, thus leading to an increase in the national debt. When the government increases the amount of debt it issues during expansionary fiscal policy, issuing bonds in the open market will end up competing with the private sector that may also need to issue bonds at the same time. This effect, known as crowding out, can raise rates indirectly because of the increased competition for borrowed funds (Hardouvelis, 2007). Even if the stimulus created by the increased government spending has some initial short-term positive effects, a portion of this economic expansion could be mitigated by the drag caused by higher interest expenses for borrowers, including the government.
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Another indirect effect of fiscal policy often overlooked, is the potential for foreign investors to bid up the currency in their efforts to invest in the now higher yielding bonds trading in the open market (Diamond and Tolley, 2013). While a stronger home currency sounds positive on the surface, depending on the magnitude of the change in rates, it can actually make American goods more expensive to export and foreign made goods cheaper to import. Since most consumers tend to use price as a determining factor in their purchasing practices, a shift to buying more foreign goods and a slowing demand for domestic products could lead to a temporary trade imbalance. These are all possible scenarios that have to be considered and anticipated. There is no way to predict which outcome will emerge and by how much, because there are so many other moving targets, market influences, natural disasters, wars and any other large scale event that can move markets (Prasad and Rajan, 2010).
Fiscal policy measures also suffer from a natural lag, or the delay in time from when they are determined to be needed, and the time their measures pass through congress and ultimately the president. From a forecasting perspective, in a perfect world where economists have a 100% accuracy rating for predicting the future, fiscal measures could be summoned up as needed (Berger and Udell, 2008). Unfortunately, given the inherent unpredictability and dynamics of the economy, most economists run into challenges in accurately predicting short-term economic changes.
Monetary can also be used to ignite or slow the economy but is controlled by the central bank, the Federal Reserve with the ultimate goal of creating an easy money environment. Early Keynesians did not believe that monetary policy had any long-lasting effects on the economy because, since banks have a choice to lend out the excess reserves they have on hand from lower interest rates, they may just choose not to lend and also that Keynesians believe that consumer demand for goods and services may not be related to the cost of capital to obtain theses goods (Fletcher, 2007).
At different times in the economic cycle, this may or may not be true, but monetary policy has proven to have some influence and impact on the economy and equity and fixed income markets. The Federal Reserve Board carries some powerful tools in its arsenal and is very active with all three. The most commonly used tool is their open market operations, which the Fed is active in on a daily basis. They purchase and sell government bonds in the open market which can increase or decrease reserves with banks while influencing the supply of money whether they are buying or selling bonds (Antonides, 2011). The Fed can also change the reserve requirements at banks thus directly increasing or decreasing the supply of money. The Fed can also make changes in the discount rate which is the tool that is constantly receiving media attention, forecasts, speculation and the world often awaits the Fed's announcements as if any change would have an immediate impact on the global economy.
The discount rate is often misunderstood, as is not an official rate that consumers will be paying on their loans or receiving on their savings accounts (Leigh, 2015). However, it is the rate that is charged to banks seeking to increase their reserves when they borrow directly from the Fed. The Fed's decisions to change this rate does, however, flow through the banking system and ultimately determines what consumers pay to borrow and what they receive on their deposits. In theory, holding the discount rate low should induce banks to hold fewer excess reserves and ultimately increase the demand for money.
In the UK monetary policy is the most important tool for maintaining low inflation. In the UK, monetary policy is set by the MPC of the Bank of England. They are given an inflation target by the government. This inflation target is 2%+/-1 and the MPC use interest rates to try and achieve this target (Hardouvelis, 2007). The first step is for the MPC to try and predict future inflation. They look at various economic statistics and try to decide whether the economy is overheating. If inflation is forecast to increase above the target, the MPC are likely to increase interest rates. Increased interest rates will help reduce the growth of aggregate demand in the economy. The slower growth will then lead to lower inflation. Higher interest rates reduce consumer spending because:
- Increased interest rates increase the cost of borrowing, discouraging consumers from borrowing and spending.
- Increased interest rates make it more attractive to save money
- Increased interest rates reduce the disposable income of those with mortgages.
- Higher interest rates increased the value of the exchange rate leading to lower exports and more imports.
Fig 2: Diagram showing fall in AD to reduce inflation
From the above study it can be concluded that role of businesses can never be underestimated in an economy. But equal importance must be given to different economic tools, methods, etc. that help governments in manging the economic and financial performance of a nation and enable it to attain success in the world market. During the report it was determined that supply side policies are critical for managing any economy in an efficient and effective manner. Herein it was revealed that UK government uses different kinds of supply side policies to control the economy. It includes the likes of privatization, income tax cuts, de-regulating financial markets, etc. Further it was also found that the government uses two tools of economy – fiscal and monetary policies to temporarily slow down the economy so that it can gain better control of country’s functioning and help it to grow and develop at a healthy rate.
Books and Journals
- Antonides, G., 2011. Psychology in economics and business: an introduction to economic psychology. Springer Science & Business Media.
- Baye, M. R. and Beil, R. O., 2009. Managerial economics and business strategy. McGraw-Hill.
- Berger, A. N. and Hannan, T. H., 2008. The efficiency cost of market power in the banking industry: A test of the “quiet life” and related hypotheses. Review of Economics and Statistics.
- Berger, A. N. and Udell, G. F., 2008. The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle. Journal of banking & finance.
- Cadsby, C. B. and Maynes, E., 2008. Choosing between a socially efficient and free-riding equilibrium: Nurses versus economics and business students. Journal of Economic Behavior & Organization.
- Cherchye, L. and Abeele, P. V., 2015. On research efficiency: A micro-analysis of Dutch university research in Economics and Business Management. Research policy.
- Cohen, W. M. and Klepper, S., 2012. The tradeoff between firm size and diversity in the pursuit of technological progress. Small Business Economics.
- Chronis, P. and Strantzalou, A., 2008. Monetary and fiscal policy interaction: what is the role of the transaction cost of the tax system in stabilisation policies? [pdf]. Available through: < http://www.bankofgreece.gr/BogEkdoseis/Paper200871.pdf >.
- Hanson, J., 2012. How can we simulate growth in the UK economy? [pdf]. Available through: < https://www.uea.ac.uk/documents/953219/967353/Hanson_Vol5.pdf/219c0990-dfb8-455b-8579-3a0c280191ca >.