Comparing policies against one another

Overview

Only supply-side measures raise an economy's long-run capacity, market-based and interventionist supply-side approaches and why supply-side policies are slow and uncertain in their effects.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What are the broad families of policy available to a government pursuing macroeconomic objectives?

   Model answer

   Demand-side policies act on total spending: monetary policy, working through interest rates, the money supply and asset purchases, and fiscal policy, working through taxation, government spending and borrowing. Supply-side policies act on the economy's capacity to produce, either by improving the working of markets or by direct provision and investment in skills, infrastructure and research. External policies act on the economy's relationship with the rest of the world, through the exchange rate regime, trade measures and controls on capital. And direct interventions act on particular prices or quantities, such as price caps, credit controls or limits on lending ratios. Most real programmes combine several of these, because each has a different speed, reach and side effect.

2. 2

   What criteria should be used when comparing one policy with another?

   Model answer

   How quickly it takes effect, and whether that matches the urgency of the problem. How precisely it can be aimed at the group, region or sector concerned. How easily it can be reversed if it turns out to be wrong or is no longer needed. Its cost, including its effect on the public finances and on the room to act in future. Its side effects on objectives other than the one being pursued, particularly on inflation, the external balance and the distribution of income. Whether it addresses the cause of the problem or only its symptoms. Whether it affects the economy's long-run capacity as well as its current level of activity. And how reliable it is, since a measure with a large but highly uncertain effect may be less useful than a smaller and more predictable one.

3. 3

   Compare monetary and fiscal policy as instruments for controlling inflation caused by excess demand.

   Model answer

   Monetary policy is generally the better instrument. It can be changed quickly and frequently by a committee without legislation, so it can respond as evidence accumulates; it is easily reversed; it works across the whole economy without the government having to choose whom to burden; and placed with a credible independent institution it anchors expectations, which does much of the work before any change is made. Fiscal tightening also reduces demand and has the advantage of improving the public finances at the same time, and raising a consumption tax affects prices directly. But it is slow to legislate and implement, hard to reverse, and every decision about which taxes to raise or which spending to cut is politically contested and distributionally charged, so it is a poor instrument for the fine adjustment that inflation control requires. The usual division is that monetary policy manages inflation continuously while fiscal policy avoids adding to demand at the wrong time.

4. 4

   Compare monetary and fiscal policy as instruments for raising employment in a recession.

   Model answer

   Monetary policy acts first, because it can be changed immediately, and cutting rates supports spending, raises asset prices and depreciates the currency. Its weakness in a deep recession is that it depends on someone choosing to borrow: if confidence has collapsed, banks are repairing balance sheets and households are repaying debt, cheaper credit produces little, and the instrument runs out entirely once rates reach their floor. Fiscal policy is slower to start but does not depend on anyone's willingness to borrow, since the government spends directly, and it can be aimed at the regions and industries where the job losses are concentrated, which a single interest rate cannot. It also works even at the lower bound, where its effect is largest because the central bank will not offset it. Its costs are the addition to debt, the difficulty of reversing it and the risk of arriving late. The sensible conclusion is that monetary policy is the first response to an ordinary downturn and fiscal policy the necessary one in a deep or prolonged recession.

5. 5

   Why can only supply-side measures raise an economy's long-run capacity?

   Model answer

   Demand-side policies change how much of the existing capacity is used. They can close an output gap, bringing idle workers and plant back into use, but once the economy is producing at its sustainable level, further demand meets a supply that cannot expand, so it raises prices rather than output. Capacity itself depends on the quantity and quality of labour, the size and vintage of the capital stock, the state of technology and the efficiency with which these are combined and allocated. Only measures that act on those things, such as education and training, investment in infrastructure and research, reform of markets that misallocate resources, and improvements in competition and in the ease of starting and expanding firms, can raise the ceiling. This is why demand management and supply-side policy are complements rather than alternatives: one determines whether capacity is used, the other determines how large it is.

6. 6

   Compare market-based and interventionist supply-side approaches.

   Model answer

   Market-based measures work by improving incentives and removing obstacles: lowering marginal tax rates on work and investment, reducing regulatory barriers to entry and expansion, strengthening competition, and reforming the benefit system so that taking work pays. They rely on private decisions to produce the response, so they cost the government little directly, but their effect is uncertain and they can worsen the distribution of income, since the gains often accrue to those already well placed. Interventionist measures involve the state providing what the market underprovides: funding education and training, building infrastructure, supporting research, and regional development. They address genuine market failures, because these activities produce external benefits that a private firm cannot capture, but they cost money, they require the government to choose correctly where to direct resources, and they can be captured by particular interests. In practice both are needed, since incentives without infrastructure and skills achieve little, and public investment without the incentive to use it achieves little either.

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