Supply-side policy — common mistakes

Always illustrate the effect of a successful supply-side policy with an AD/AS diagram. Show and explain the rightward shift of the LRAS curve, leading to a higher potential Real GDP (Yfe) and a lower price level.

When discussing tax cuts as a supply-side policy, clearly explain the incentive mechanism. For example, 'Lower corporation tax increases post-tax profits, providing firms with both the incentive and the means to invest in new capital, boosting productive capacity.'

Do not confuse interventionist supply-side policies with expansionary fiscal policy. While both may involve increased government spending, the intent differs. Fiscal policy targets short-run aggregate demand, whereas interventionist supply-side policy targets long-run aggregate supply.

For a top-level evaluation, consider the specific economic context. For example, in a developing country with poor infrastructure, interventionist spending on transport would be highly effective. In a high-tax developed country, a market-based policy of tax reform might be more appropriate.

In combined macro essays, use two diagrams: one showing AD shift (demand-side) and one showing LRAS shift (supply-side). Examiners reward distinguishing short-run and long-run effects.

It can be both, and it is crucial to distinguish the two effects. As a demand-side (fiscal) policy, lower income tax increases households' disposable income, boosting consumption and aggregate demand. As a supply-side policy, the aim is to increase the incentive to work. It may encourage the unemployed to take a job or existing workers to work more hours, thus increasing the size of the labour force and shifting LRAS to the right.

While their primary objective is to increase long-run aggregate supply, they can have short-run effects. For instance, announcing a major infrastructure project can boost business confidence and investment (an AD component) in the short run. However, their main purpose and the criteria by which they are judged relate to their long-term impact on the economy's productive potential and the LRAS curve.

No, their success is not guaranteed and they are subject to government failure. Interventionist policies can be inefficiently managed, leading to wasted resources (e.g., building infrastructure that is not needed). Market-based policies can have unintended consequences; for example, deregulation might lead to a decline in safety standards or environmental quality, and tax cuts may be used to fund higher dividends for shareholders rather than for new investment.