Unit 2 keys points to prepare for exam - supply side policies

Question 1

What are supply side policies?

Answer 1

Supply side policies focus on influencing the factors affecting AS; intend to shift the AS curve to the right.
Shifting the AS curve to the right can lead to sustained economic growth which increases national income but keeps prices stable

Question 2

What are the range of factors which can cause the AS curve to shift

Answer 2

Y = A F (L,K)
A = institutions, educations research, innovation, market structure
L = demographics, social benefits, professional training
K = capital market structure, taxation, pensions, competition

Question 3

What would shifting the AS curve to the right do?

Answer 3

Shifting the AS curve to the right would increase the capacity of the economy and increase national income and thus employment and reduce pressure on prices

Question 4

Structural polies vs supply side policies

Answer 4

• Making the central bank independent or choosing a new currency regime -> structural reforms
• Conversely, a change in tax rates, which is mostly a supply side measure does not have the character of a structural reform

Question 5

Supply side policy - short term

Answer 5

Short term (around 1 year or less)
- Stimulate labour supply through policies that favour participation in the labour force
- E.g. regulations on the retirement age or change to tax rules

Question 6

Supply side policies - medium term

Answer 6

In the medium term (a few years) stimulate capital accumulation through,
- tax incentives
- competition
- public capital investment

Question 7

Supply side policies - long run

Answer 7

• Affect the quantity and quality of the labour force
• Have a bearing on total factor productivity through the funding of research, infrastructure etc

Question 8

Sorting out policies according to time horizon

Answer 8

Politicians tend to confuse long-term and short-term policies and ignore their interactions:
- Politicians and voters may wrongly attribute long-term performance to monetary and fiscal policy

Question 9

3 arguments between long term trends and short-term fluctuations

Answer 9

1. Macroeconomic instability leads to precautionary behaviour:
   - For households: increased uncertainty over income makes individuals consume less and invest more in safer securities
2. Unemployment hysteresis:
   - When employees having lost their jobs in an economic downturn remain lastingly unemployed, their skills deteriorate and they become less employable
3. Creative destruction:
   - The concept where recessions are seen as having both positive and negative impacts on businesses and their innovation
   - Positive view: recessions are productive as they eliminate less efficient firms, making room for new and better ones
   - Negative view: recessions can lead to irreversible losses

Question 10

Boost labour supply in the short term

Answer 10

Short term policies include stimulating labour supply though changes in retirement age and tax/benefit rules

Question 11

Policies to boost labour supply in the long term

Answer 11

The only policies that can contribute to sustaining the growth rate of the labour force in the long run are measures aimed at increasing the fertility rate and immigration.
- Fertility rate can be raised by providing childcare facilities so that there is not an obstacle to raising children
- In the US inward migration has contributed to significant increase of the labour force

Question 12

The importance of physical capital and human and social capital

Answer 12

While physical capital is still considered a key element in growth, it is now generally recognised the importance of other types of capital.
- Human capital: knowledge, skills, experiences etc
- Social capital: networks, relationships etc

Question 13

Role of financial systems/markets in physical capital accumulation

Answer 13

1. Lower cost of capital
2. Higher savings
3. Better allocation of capital

Question 14

Lower cost of capital - financial system in physical capital accumulation

Answer 14

Public policies can affect the cost of capital through:
1. Monetary policy
- Directly affects short term interest rates
- Indirectly, medium and long term interest rates
2. Regulatory policies
- Bank and capital market regulation have an impact on the cost of capital
3. Tax policies
- Through tax on corporate earnings, taxes on capital assets, notably real estate

Question 15

Higher savings - financial system in physical capital accumulation

Answer 15

In simple terms, when money can easily move between countries, a country’s investments are not limited by how much its people save. This means there’s less need to encourage people to save more. However, governments still often try to boost savings, like through pension reforms that require people to save for retirement. These savings can help grow the economy if invested in things like company bonds or stocks.

Governments can also influence the allocation of savings through
- Fiscal incentives can channel savings (e.g. to finance innovation through R&D tax credits)
- Tax policy and regulatory policies influence decisions to invest in equity, bonds or housing

Question 16

Total factor productivity

Answer 16

In the long term, the growth of the productive capacity of an economy depends on TFP growth which includes:
- Improve the institutional environment
- Invest in education, RDI
- Improve the functioning of markets

Question 17

Policies to improve the institutional environment - TFP

Answer 17

Governments should:
1. Ensure that the legal framework in which the economy operates in conducive to private initiative -> creating an independent judiciary to enforce private contracts, fighting corruption etc
2. Put in place effective market regulation -> developing proper banking regulation, ensuring consumer protection
3. Achieve macroeconomic stability -> e.g., an independent central banks, appropriate fiscal rules

It is important the quality of institutions -> institutions matter

Question 18

Policies to invest in education- TFP

Answer 18

Education:
- The rate of return to education is hard to measure, since education does not play a direct role in production
- Studies (mainly from the World Bank) have confirmed that:
1. Primary education exhibits the highest social profitability in developing countries
2. Tertiary education is more relevant in OECD countries
- To improve the performance of European education, money is not enough -> long-term planning, quality of governance, quality of teaching

Question 19

Policies to invest in RDI - TFP

Answer 19

Two groups of indicators are frequently used to measure research and innovation.
1) the first group covers the effort of each country in terms of RDI spending or personnel
- Europe is behind Japan and the US hence the objective of bringing R&D expenditures to 3% of GDP in Europe
2) the second group of R&D indicators relates to outcomes

Policies to invest in RDI
- Government support and private initiative
- Patent protection
- Taxation support

Question 20

Policies to invest in Infrastructure - TFP

Answer 20

Economic development requires proper infrastructure such as schools etc
Such infrastructures are often financed by
- Governments, or by foreign aid
- Private money as countries grow richer

There is a need for government intervention:
1) many infrastructures are natural monopolies
2) infrastructures involve externalities
3) in some instances the market cannot finance infrastructure by itself
Governments have tried to appear as catalysts more than as primary funders of public infrastructure investment

Question 21

Policies to improve the functioning of labour markets - TFP

Answer 21

Active labour market policies:
- Guidance and assistance services in job search
- training
- direct job creation

Reforms of labour market institutional framework
- Rules regulating hiring and dismissal conditions
- Rules governing minimum wage, working hours etc
- rules related to the social protection of workers (unemployment benefits)

US: little governance involvement in the labour market, and the short duration of unemployment insurance acts as a strong incentive for the unemployed to take up a new job

Question 22

Policies to improve the functioning of the product market - TFP

Answer 22

1. Inverted U relationship between competition and innovation.
   - We need enough competition for incumbent firms to be challenged by new entrants
   - But too much competition in product markets -> reduces the monopoly rent that rewards it ->discourages innovation
2. Governments have to make sure that:
   - Markets deliver appropriate price and quality
   - Competition is not stifled by collusion among existing players