Demand-side and Supply-side Policies on Economic Growth - Case Study Example

Demand-side And Supply-side Policies on Economic Growth Demand side policies are those policies that aim at altering the demand in the economy by increasing aggregate demand. They are brought forward by the government during recessions and periods of below trend growth in order to stimulate the components of aggregate demand and are designed to affect the spending ability in an aggregate economy. These changes are deliberately brought into action by the government on its expenditure and income so as to achieve the vital objective of the economy like economic growth and a reduction in unemployment. These policies are either expansionary (catalyze spending in a recessionary economy) or contractionary (reduce spending in an inflationary economy). Also, supply side policies are those policies employed by the government to increase the country’s productivity hence shifting the aggregate curve outwards. They also are designed to affect an economy’s ability to produce goods and services. They increase the country’s aggregate productivity over time and improve the potential of the economy to produce. These policies are always expansionary with an aim increasing an economy’s production capacity which translates into increased living standards (Sloman, 2006). Demand side policies are further broken down to fiscal and monetary policies. Fiscal policies are those policies that are aimed at bringing changes in the government spending or taxes collected while monetary policies aim at bringing changes to the money supply engineered by the central bank. Expansionary policies are then defined as those policies designed to stimulate economic growth through changes in real Gross Domestic Product (GDP) and the potential output of the economy (Economics Online, 2013). The policies are characterized and implemented in the demand side by any of the four categories of expenditure i.e. consumption expenditure, investment expenditure, government expenditure, or net export expenditure that constitutes the Gross Domestic Product (GDP). On the supply side, the expansionary policies are designed to add flavor to the capacity of production of the economy through labor policies (education, immigration, retirement), capital accumulation, research and development (seeking technological improvements), or promotion of resource availability. Monetary policies lower rates of interest that accompany an increase in money supply hence affecting investment expenditure. A monetary policy would increase the amount of local currency available in the exchange market which will then weaken the rates of exchange with other currencies. Also, the lower rates of interest will make the economy unattractive to investors when compared to other economies which will lead to a capital overflow resulting in the sale of domestic assets and the currency in the exchange market resulting in an ultimate weak currency. A weaker currency makes exports relatively cheaper to foreign buyers hence will stimulate the demand for the local goods while at the same time imports will be more expensive to domestic buyers leading to a reduced demand for imported goods (Pettinger, 2011). This will result in an increase in Net Export expenditure. In times of large deficits in the budget, fiscal policies tend to be missing from the policy maker’s ideologies. These policies are easy to legislate as they are politically popular and supported. Monetary expansionary policies are ineffective and unpredictable compared monetary contractionary (Sloman, 2006). In a case where the weak economic growth or high level of unemployment worries the Federal Reserve, the policy will react by increasing bank reserves by open market purchase (where the central bank buys or sells government bonds on the open market to manipulate the short term interest rate and supply of base money in an economy) prompting banks to convert their reserves into loans to their customers. Loans are offered at low borrowing rates. The incentive to invest in inventories or productive capacity is eliminated by a sluggish economy matched by a sluggish demand for goods and services. Contrary, contractionary policies are always effective. Open market operations to remove reserves from banking system require banks to create competition for fewer available loans by pushing interest rates higher thus making investment projects unprofitable leading to their abandonment (S-Cool, 2013). The pull of reserves from the banking system and elevation of interest rates reduces spending on investment. The ease at which expansionary policies find their way in the political arena makes them often used for economic policy purposes at the expense of the contractionary policies. We therefore focus on how the expansionary policies influence economic growth. These policies include increased government expenditure, and reduced taxes. They are typically used in an economy operating below its potential i.e. resources are available in excess for production leading to little pressure exerted on levels of price by these policies. In Keynes’s reaction to the great depression, he suggested that governments could stimulate effective demands for goods where demand was lacking in the private sector. He gave a literal interpretation where a government could take bank – notes and stack in bottles then burry the bottles around the country. Individuals would use effort to retrieve the notes and spend some if not all of this newly discovered purchasing power. In practice, Keynes’s suggestion states that governments can stimulate spending in a similar manner by spending on necessary public projects including administrative buildings, roads, dams, and other infrastructure thus prompting the unemployed to working in the gainful industries. The legitimate income earned from these industries is then spent on goods and services. This spending would then lead to inventory depletions which translates to additional employment in the production industry and replenishment of these inventories. Through this process, we notice an increase in demand thus Real Gross Domestic Product would edge closer to the economy’s potential. Expansionary monetary policies can be used for the same reasons as expansionary fiscal policy – weak aggregate demand and an economy operating below its potential. This policy is used by the Federal Reserve when there is no doubt of inflation becoming a problem because of the policies i.e. nominal interest rates equals the real rates. The Federal Reserve employs open market operations to retrieve government securities from the hands of treasury dealers and pays for them using newly created reserves (Gwartney, 2008). The Federal Reserve trading desk will exert pressure on these prices of the bonds thus driving their yield downwards. The reserves then after finding their way into the banking system as excess reserves are then converted into new loans available to customers for borrowing at lower rates of interest. In a case of contractionary monetary policy, the Federal Reserve reacts to inflationary pressure in the economy resulting from increase in purchasing power or reduction in potential output perhaps due to adverse shocks in productivity or an increase in prices of factors of production. In such cases, the spending ability of the economy exceeds its ability to produce leading to upward pressure on output prices. The Federal Reserve then reacts to combat the situation by increasing interest rates and increasing borrowing costs to weaken spending on investment hence shifting the aggregate demand back (Setterfield, 2002). The open market sale of government securities increases the number of the securities in the secondary market for bonds hence forcing their prices to drop and their yields to rise. However demand side policies have itches like time lag between changes in taxes and rates of interest and their actual effect on aggregate demand. Interest rate cuts may not have much effect on increasing consumption if there is low consumer confidence. Also, an increase in aggregate demand can easily conflict with government objectives of low inflation if the economy is close to full capacity. Again, aggregate demand may lead to inflation because the long run aggregate supply is inelastic which interprets to no growth in the economy unless both aggregate demand and aggregate supply are increasing. Also, these demand side policies in trying to increase growth in the long run end up causing an unsustainable boom and bust. In some cases, the demand side policies can be used to limit the growth of aggregate demand as it is necessary to avoid an economic boom where growth becomes unsustainable and inflationary. Supply side policies can be effected through aggregate production function by affecting the availability of input factors or their productivity. These policies are categorized into three factors of production (labor, capital, and availability of raw materials). According to Nagel (2000) labor – input components have been used by policy makers in an attempt to increase an economy’s potential output. In an attempt to increase the supply of labor, the policies have led to the introduction of other policies like relaxed immigration policies (allow migrants into the country to beef up the available labor), population policies (where births are encouraged), and/or increasing rates of participation of the labor force. The policies further attempts to increase labor productivity through improved access to education and designing of policies that make educational activities effective (S-Cool, 2013). Different policies have effected a nation’s capital stock that is so important for rising living standards. Infrastructure that reduces market activity associated transaction costs as well as one that complements and enhances the movement of goods and services are often directly created by the government and they may include roads, bridges and dams, airports, and improvement to waterway shipping. This infrastructure may also include legal systems, courts and police to help ease market transactions. Through grants and subsidies for research, creations of capital, and development, the policy makers can encourage accumulation of capital in the private sector. Tax laws also favor capital through lowering the borrowing costs hence encouraging spending in investment i.e. spending on new capital while replacing old existing capital. Availability of raw materials also plays an important role in the structuring and strengthening of an economy. Policies are developed that improve access to raw materials and their availability (Brin and Brin, 2010). These kinds of policies may dictate different land – use allowing for resource extractions, logging, oil exploration, and urbanization. These policies often attract strong debates in the political arena as they run counter to environmental protection efforts. Another supply side policy would be to follow a program of privatization and deregulation. The government can sell government owned industries to the private sector. The private sector will increase the efficiency with its profit incentive. However, this policy may give rise to private monopolies that tend to exploit consumers. It is also argued that lower income taxes can serve as incentives to work and increase labor supply. However the income and substitution effect comes into play as higher taxes make people to worker longer to achieve their targets. In conclsion, the supply side policies can help in improving productivity in the long run though there is a limit to what can be done by the government to increase productivity i.e. there are factors that the government has no powers over like technology and working ethics. Also the government may not have any control over global events that affect the growth of the economy. References: Brin, D., and Brin, C., 2010. A Primer on Supply-Side vs Demand-Side Economics, [Online] (updated 20 Feb. 2010) Available at: [Accessed 23 Apr. 2013]. Economics Online, 2013. Supply-side policy, [Online] (updated 23 Jul. 2013) Available at: [Accessed 25 Apr. 2013]. Gwartney, J., 2008. The Concise Encyclopedia of Economics: Supply-Side Economics, [Online] (updated 12 Mar. 2008) Available at: [Accessed 25 Apr. 2013]. Nagel, S.S., 2000. Handbook of Global Economic Policy, New York: Marcel Dekker. Pettinger, T., 2011. Factors Affecting Economic Growth, [Online] (updated 22 Feb. 2011) Available at: http://www.economicshelp.org/blog/2671/economics/factors-affecting-economic-growth/ [Accessed 24 Apr. 2013]. S-Cool, 2013. Supply Side Policies: What are supply side policies? [Online] (updated 07 Jan. 2013) Available at: [Accessed 24 Apr. 2013]. Setterfield, M., 2002. The Economics Of Demand-Led Growth: Challenging the Supply-side Vision of the Long Run, Cambridge: Edgar Elgar. Sloman, J., 2006. “Supply side policies,” Economics, (6th ed.), London: Pearson, [Online] (updated 10 Jun. 2006) Available at: [Accessed 23 Apr. 2013]. Read More