> ECONOMICS FOR THE IB DIPLOMA: COURSEBOOK > 13.5 Further topics on the multiplier and Keynesian economic theory (Supplementary material recommended for HL only) If you are interested in exploring these issues further, a better understanding of aggregate demand and its you will ind a discussion in the digital coursebook. relationship to aggregate output (real GDP), and is ‘The first part examines the relationship between the also useful background to a deeper understanding of ‘multiplier and fiscal policy more closely. The second the multiplier. part presents the Keynesian cross model which allows 13.6 Supply-side policies LEARNING OBJECTIVES13 Demand-side and supply-side policies Goals of supply-side policies The goals of supply-side policies include the following: © Promote long-term growth by increasing the productive capacity of the economy. The main objective isto increase potential output, shown by a steeper long-term growth trend in the business cycle diagram, or rightward shifts of the LRAS curve (or Keynesian AS curve). ‘* Improve competition and efficiency. The objective is to make the economy more responsive to the market forces of demand and supply 30 as to inerease efficiency in production. © Reduce costs of labour and reduce unemployment through greater labour market flexibility. Greater labour market flexibility means making the labour market more responsive to the market forces of demand and supply so as to reduce unemployment as well as labour costs. ‘+ Increase incentives of firms to invest in innovation by lonering costs of production. Higher after-tax profits through lower costs of production as well as lower taxes provide firms with incentives to engage in research and development that increases the productive capacity of the economy resulting in ‘greater increases in productive capacity and growth in potential output. + Reduce ination to improve ternational ‘competitiveness. Increases in potential output reduce inflationary prescures in the economy, thus making exports more competitive in global markets. ‘There are two types of supply-side policies: market- based and interventionist. Market-based policies emphasise the importance of well-functioning competitive markets, and are usually favoured by monetarist/new classical economists, Interventionist policies rely on government intervention to achieve growth in potential output, and are usually favoured by economists influenced by Keynesian thinking. Market-based supply-side policies In the early 1980s, some highly influential monetarist’ ‘new classical economists n the United Kingdom and the United States began to emphasise the view that growth in real GDP depends on the supply side of the economy. This view was adopted by the government headed by Margaret Thatcher in the United Kingdom, and by the government under Ronald Reagan in the United States. Since then, many governments throughout the world have pursued policies influenced by market-based supply- side thinking. In this view, the economy’s real GDP tends automatically towards long-run full employment ‘equilibrium and potential GDP (see Chapter 9). The focus of government policies should therefore be to create conditions that allow market forces to work well. ‘This perspective sugsests that an economy pursuing supply- side policies will be able to achieve rapid growth, price stability and full employment all atthe same time. As the ‘economy tends towards full employment equilibrium, it automatically eliminates recessionary and inflationary gaps. If increases in aggregate supply match increases in aggregate ‘demand so that the LRASand SRAS curves! shift by the same amount as the AD curve, there need not be any price level increases. See Figure 11.3(a) in Chapter 11 Market-based supply-side policies can be grouped under three headings: 1 Fneouraging competition 2 Labour market reforms 3° _Incentive-related policies Encouraging competition Greater competition among firms forces them to reduce costs, contributing to greater efficiency in production and improving resource allocation, with the possible added benefit of improving the quality of goods and services. These benefits will allow potential output to increase and the LRAS curve to shift to the right. © Privatisation, Privatisation, involving a transfer of ‘ownership of a firm from the public to the private sector, can inercase efficieney duc to improved ‘management and operation of the privatised firm. This is based on the argument that government enterprises are often inefficient due to bureaucratic procedures, high administrative costs and ‘unproductive workers, because they do not face incentives to lower costs and maximise profits. © Deregulation. Deregulation involves elimination or reduction of government regulation of private sector activities, based on the argument that government regulation stifles competition and increases “See Chapter9 Section The relationship between the SRAS and LRAS curves in the monetarist/new clasical model for an explanation of why SRAS also shift, a3)> ECONOMICS FOR THE IB DIPLOMA: COURSEBOOK inefficiency. There are two main types of regulation (and deregulation): economic and social. Economic regulation’ involves government control of prices, ‘output, and other activities of firms, offering them protection aeainst competition. In the last two to three decades, many countries have moved toward removal of government regulations, and hence economic deregulation. A main form of deregulation has been to allow new, private firms to enter into ‘monopolistic or oligopolistic industries, thus foreing existing firms to face competition. The objective has been to increase efficiency, lower costs and improve quality. Industries affected include transport, airlines, television broadcasting, telecommunications, ‘natural gas, electricity, financial services and others. ‘Social regulation’ involves protecting consumers against undesirable effects of private sector activities (many of these involve negative externalities) in humerous areas, including food, pharmaceutical and other product safety, worker protection ‘against injuries, and pollution control. In contrast to evouumic regulation, social regulation is being strengthened in many countries in the interests of public safety. Some economists, however, argue that social regulation is excessive, giving rise to costly and inefficient bureaucratic procedures, paperwork and lunnecessary government interference, and should therefore be reduced. * Contracting out to the private sector. This isa policy option whereby governments make a contractual agreement with private firms to provide goods and services for the government (see Chapter 6). Examples include public goods, information technology, human resources management and. ‘accounting services. These result in increased ‘competition as private firms compete with each other to get contracts with the government. ‘+ Anti-monopoly regulation, Increased competition can result from restricting market power of firms by enforcing anti-monopoly legislation, by breaking up large firms that have been found to engage in monopolistic practices into smaller units that will behave more competitively, and by preventing ‘mergers between firms that might result in too much market power. Greater scope for the forees of supply ‘and demand may result in increased efficiency, lower ‘costs and improved quality. ‘© Trade liberalisation, International trade between ‘countries has become freer (liberalised) in recent decades due to reductions in trade barriers, Free or freer trade increases competition between firms both domestically and globally, which can result in greater efficiency in production and an improved allocation of resources (we will study this in Chapter 14). Labour market reforms Labour market reforms are sometimes referred to as increasing labour market flexibility, oF reducing labour ‘market rigidities discussed in Chapter 10 as one cause of structural unemployment. Labour market reforms jended to get rid of rigidities by making labour ‘markets more competitive, making wages respond to the forces of supply and demand, lowering labour costs, and increasing employment by lowering the natural rate of unemployment. Lower costs of production can lead to inereased profits, which in turn may result in greater investment by firms, increased R&D. increased capital ‘goods production, and therefore increases in potential ‘output (economic growth). Labour market reforms include: * Abolishing minimum wage legislation. Elimination or reduction of the legal minimum wage it is argued, reduces unemployment by allowing the equilibrium ‘wage to fall. The benefits would include lower tunemnployment; greater firm profits as wage costs would ‘be lowered; more investment and economic growth. ‘This can be seen in Figure 10.1(b) (Chapter 10), + Weakening the power of labour (trade) unions. A labour union, or trade union, is an association of workers in a particular profession. whose ‘objective is to improve working conditions and. defend rights of workers, representing its members {in negotiations with employers. Unionised labour frequently succeeds in securing high wage increases; if labour unions are weakened, wages will be more responsive to the forces of supply and demand, and will therefore be more likely to fallin if there is unemployment. This would also lead to the same benefits as abolishing minimum wage legislation, + Reducing unemployment benefits, 1t is argued that ‘unemployment benefits have the unintended effect of reducing the incentive to search for a new job, causing some unemployed workers to remain unemployed for longer periods than necessary. Therefore, reducing unemployment benefits is expected to lower unemployment, as it would encourage the ‘unemployed to look for work. This could work to reduce the natural rate of unemployment. + Reducing job security. Many countries have laws protecting workers against being fired, making it costly for firms to fire workers because of high ay13 Demand-side and supply-side poli levels of compensation that must be paid to the worker being laid off It is argued that reducing workers’ job security by making it easier and less costly for firms to let go of workers has the effect of increasing employment, because firms are more likely to hire new workers if they know they can fire them easily and without cost if they are no longer needed. In addition, redicing job security would decrease firms’ labour costs because of the lower costs of firing, and would therefore increase profits, investment and economic growth. Incentive-related policies Incentive-related policies involve cutting various types Of taxes, which are expected to change the incentives faced by taxpayers, whether firms or consumers * Lowering personal income taxes. As we know, cuts in personal income taxes ean increase aggregate demand. Supply-side economists argue that changes in personal income taxes have an even greater impact on ageregate supply because they lead fo higher after-tax incomes ‘creating an incentive for people to provide more work this can happen through an increase in the number of hours worked per week; an increase in the number of people interested in finding work (who were formerly ‘not interested in working), an increase in the number of years worked, as people may decide to retire later; decrease in unemployment as nemplayed workers choose to shorten the duration of their unemployment. All these factors may work to shift the LRAS curve to the right, increasing potential output. ‘+ Lowering taxes on capital gains and interest income. ‘axes on capital gains are taxes on profits trom financial investments (such as stocks and bonds) or from buying and selling real estate. Ifthe taxes on ‘capital gains and on income from interest on savings deposits are reduced, people may be more motivated to save, thus increasing the amount of savings available for investment. More investment means @ ‘greater production of capital goods and an increase in potential output. * Lowering business taxes. Lower taxes on business profits (corporation taxes) can work to increase aggregate demand by increasing investment spending. ‘Supply-side economists argue that cutting taxes ‘on firms’ profits isa supply-side measure because ‘nereases in the level of after-tax profits mean that firms have greater financial resources for investment and for pursuing technological innovations through ‘more R&D, resulting in greater potential output. Interventionist supply-side policies Interventionist supply-side policies presuppose that the free market economy alone cannot achieve the desired results in terms of increasing potential output, and therefore government intervention is required. Investment in human capital: education and health services Investment in human capital can take the following, important forms: + ‘Training and education. More and better training and education lead to an improvement in the quality of labour resources. increasing the productivity of labour, which is one of the key causes of economic growth (see Chapter 11). Education also has numerous positive externalities, justifying {government intervention. Public training and education programmes can assist workers to become ‘more employable, thus reducing the natural rate of unemployment, Specific measures include setting. up retraining programmes for structurally unemployed ‘workers to obtain skills in greater demand; assisting young people to pursue training and education ‘through grants or low interest loans; direct government hiring and provision of on-the-job training: providing grants to firms that offer on-the-job traning; offering subsidies to firms that hire structurally unemployed workers; assisting workers to relocate to geographical areas where there isa greater demand for labour ‘through grants and subsidies (Such as provision of Jow-cost housing); providing information on job availabilty in various geographical areas; establishing government projects in the depressed areas that result in new employment creation. + Improved health care services and access to these. When \workers and the general population) have access to ‘200d quality health care services, they become healthier and more productive. More and improved health care services and access to these by the working population is another factor leading to improvements in the quality of labour resources increasing the economy's ‘potential output. Health care also has many positive externalities, justifying government intervention. Investments in human capital result in an increase in aggregate demand over the short term, and over the longer-term lead to increases in potential output, by shifting the LRAS or Keynesian AS curves to the right. 415)> ECONOMICS FOR THE IB DIPLOMA: COURSEBOOK Investment in new technology: research and development Rescarch and development (R&D) is the fundamental activity bebind the development of new technologies, resulting in new or improved capital goods (physical . capital), which is another important cause of increases in potential output and economic growth (see Chapter 11). R&D also has positive production externalities, thereby justifying government intervention, Governments in many countries around the world are therefore heavily involved in R&D. In addition, governments often provide incentives to private sector ties; these usually take the form of tax incentives, as well as the granting of patents for the protection of inventions Government spending in support of new technology development leads to increases in aggregate demand over the short term and inereases in potential output over the longer term shifting the LRAS or Keynesian AS curves to the Investment in infrastructure Infrastructure is a type of physical capital, and therefore results from investment; it includes power, telecommunications, roads, dams, urban transport, ports airports irrigation systems, ete. Many types of infrastructure qualify as merit goods or public goods, ‘thereby justifying government intervention. More and better infrastructure increases efficiencies in production as, itlowers costs: Good roads, railway and other transport systems, for example, save time and effort spent in transporting goods and services, allowing more output to be transported and costs to be lowered. The availabilty of effective telecommunications permits faster and easier ‘communications, enabling economic activities to be carried out more efficiently: More and better infrastructure improves labour productivity. Investments in infrastructure therefore work to increase aggregate demand over the short term, but they also contribute to increases in potential output and 4S increases over the longer term. Industrial policies Industrial policies are government policies designed. to support the growth of the industrial sector of an economy. They include: ‘+ Support for small and medium-sized enterprises or firms (SMEs). This may take the form of tax guidance. These measures provide support for the private sector, promoting efficiency, more capital formation, more employment possibilities and therefore increases in aggregate demand as well as potential output. ‘Support for infant industries’ Infant industries’ are newly emerging industries in developing countries, which sometimes receive government support in the form of grants, subsidies, tax exemptions, and tariffs or other forms of protection against exports (see Chapter 14). This also provides support for growth. of the private sector and increases in aggregate demand and growth in potential output. 2 Explain the goals of supply-side policies. b Outline the two categories of supply- side policies noting how they differ in their general focus. Using an appropriate diagram based on the AD-AS model, ilustrate and explain the expected impacts of supply-side policies on real GDP, the price level and unemployment. (You may use the Keynesian or monetarist/new classical model to illustrate.) a Provide some examples of interventionist supply-side policies. b Using a diagram, explain how these policies affect aggregate demand over the short term and also increase LRAS. © Show these effects using the Keynesian AD-AS model. Explain why supporters of market-based supply-side policies argue that by focusing on the supply side of the economy, it is possible to address the policy goals of economic growth, price stability and Unennployrient ell at Uie same tine, Outline what advantages supply-side licies might have over demand-side policies in the event that an economy is experiencing stagflation (simultaneous inflation and unemployment with recession) exemptions, grants, low-interest loans and business a>