Unit 2 Macro: How can supply-side policies help in a recession?

Recessions are often the result of negative demand-side shocks that hit real incomes of consumers and demand and profits for businesses. The consequences show through in higher unemployment, a fall in capital investment and an increasing rate of business failures. Most macroeconomic policies in a recession centre on boosting demand and confidence in a bid to generate a rebound in output, jobs and incomes within the circular flow.

What role can supply-side policies play during an economic downturn?

The key to answering this is to understand the range of policies that have a supply-side dimension or have supply-side effects! Here are some examples to consider:

1/ Increased capital spending on an economy’s critical infrastructure - much of this might be funded by the government for example bringing forward some investment spending on hospital re-building, transport projects and environmental schemes. Other big capital spending projects might be partly financed by the private sector perhaps as part of a spublic private partnership. These projects are often labour-intensive and can create a sizeable multiplier effect on demand.

2/ Reductions in business taxation - for example lowering the standard rate of corporation tax (to stimulate investment) or reducing employers’ national insurance contributions (to boost the demand for labour). Lower taxes for business research and development spending or tax relief for inward investment projects also have a supply-side aspect to them

Note that 1/ and 2/ are examples of fiscal supply-side policies - where fiscal policy is being used to drive a stronger supply-side rather than manage aggregate demand.

3/ Reforms to the welfare system to improve work incentives for example help in improving the affordability of child-care

4/ Policies designed at improving the quality of and access to education and training for all. This is particularly relevant when coming out of a recession because many of the new jobs in an economy as recovery gathers momentum are not in the same industries as before a downturn. It is hugely important to prevent cyclical unemployment from turning into structural unemployment

5/ Measures to stimulate business start-ups - seed corn finance and other help for new enterprises can provide a flow of new jobs as an economy picks up

6/ Policies to maintain the openness to trade and investment from overseas - instead of choosing protectionist policies, politicians should understand the importance of trade and competition as a means of generating new demand and creating extra jobs

7/ Policies to increase the supply of affordable housing either to buy, part buy/rent or to rent

A strong supply-side is vital if an economic recovery is to be sustained. The worry for Britain at the moment is that government finances are in such a bad state that higher taxes and cut backs in state sector spending are inevitable and this may hamper the ability of the private sector to deliver the investment and productivity improvements needed to create fresh growth after the 2008-10 recession.