MacroEconomics: what is the supply side policy and how does it work. Without diagrams (text only)

1.0. SUPPLY-SIDE POLICIES
1.1 Objectives of Supply-side Policies
Supply-side policies are policies that are used to increase the production capacity in the economy and hence aggregate supply. The production capacity in the economy can be increased through increasing the quantity or the quality of the factors of production in the economy. Although supply-side policies are used to increase the production capacity in the economy, they may also decrease the cost of production in the economy. For example, in addition to an increase in the production capacity in the economy, an increase in the quality of labour or the quality of capital in the economy will lead to an increase in labour productivity and hence a fall in the cost of production in the economy resulting in an increase in aggregate supply. Potential economic growth is an increase in potential output and actual economic growth is an increase in actual output. An increase in the production capacity in the economy and hence aggregate supply will lead to potential economic growth. Potential economic growth per se will not lead to a rise in the standard of living. However, as actual economic growth is constrained by potential economic growth, potential economic growth is essential for achieving sustained economic growth. Apart from potential economic growth, an increase in the production capacity in the economy and hence aggregate supply will also lead to actual economic growth, although to a lesser extent. In addition, assuming aggregate demand is rising which is the normal state of the economy, an increase in the production capacity in the economy and hence aggregate supply will lead to lower inflation. Supply-side policies can be classified into interventionist supply-side policies and market-oriented supply-side policies. Interventionist supply-side policies are policies that are used to increase the production capacity in the economy and hence aggregate supply through government intervention that reduces the deficiencies of the market. Market-oriented supply-side policies are policies that are used to increase the production capacity in the economy and hence aggregate supply by freeing up the market. The following is a list of supply-side policies that are useful for the examination.
1.2 Interventionist Supply-side Policies
1.2.1 Education and Training
Education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy. The government can provide education and training directly, by setting up educational institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage them to send their workers for education and training. For example, the Singapore government has set up the Institute of Technical Education, polytechnics and Continuing Education and Training campuses to provide education and training.
1.2.2 Research and Development
Research and development will lead to technological advancement which will increase the efficiency of capital in the economy. The government can engage in research and development directly, by setting up research institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage them to engage in research and development. For example, the Singapore government has set up the Biomedical Research Council (BMRC) and the Science and Engineering Research Council (SERC) under the Agency for Science, Technology and Research (A*STAR) to engage in research and development.
1.2.3 Infrastructural Development
Government expenditure on infrastructure will increase investment expenditure which will lead to a more rapid increase in the quantity of capital in the economy. For example, the Singapore government has provided infrastructures such as Jurong Island for high-end chemical manufacturing and Biopolis for pharmaceutical manufacturing which have attracted many foreign high-end chemical firms and pharmaceutical firms to invest in Singapore. Market-oriented Supply-side Policies
1.2.4 Privatisation
Privatisation refers to the conversion of a state-owned firm to a private firm. Unlike state-owned firms, private firms need to consider factors such as profitability and survival. Therefore, privatisation will induce firms to increase labour productivity to reduce costs. It may also lead to an increase in the number of firms in the market and hence greater competition which will induce firms to increase labour productivity to reduce costs. To increase labour productivity, firms will adopt better production technologies or engage in research and development and engage in education and training. Adopting better production technologies and research and development will lead to technological advancement which will increase the efficiency of capital in the economy. Education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy.
1.2.5 Deregulation
Deregulation refers to the removal of restrictive regulations. Deregulation will lead to an increase in the number of firms in the market and hence greater competition which will induce firms to increase labour productivity to reduce costs. To increase labour productivity, firms will adopt better production technologies or engage in research and development and engage in education and training. Adopting better production technologies and research and development will lead to technological advancement which will increase the efficiency of capital in the economy. Education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy.
1.2.6 Cuts in Income Taxes and Capital Gains Tax
A decrease in personal income tax will increase after-tax personal income resulting in an increase in the quantity of labour in the economy. A decrease in corporate income tax will increase expected after-tax returns on planned investments and hence investment expenditure resulting in a more rapid increase in the quantity of capital in the economy. A capital gains tax is a tax imposed on the profit from the sale of a certain type of asset. For example, many governments impose a capital gains tax on the profit from the sale of properties. A decrease in capital gains tax on properties will increase the incentive to invest and hence investment expenditure resulting in a more rapid increase in the quantity of capital in the economy.
1.3 Labour Market Reforms
The government can implement labour market reforms to increase the quantity of labour in the economy. For example, it can increase retirement age and incentivise firms to employ older workers through subsidies or tax incentives. It can encourage firms to provide flexible work arrangements which will encourage non-working mothers to enter the labour force. It can loosen restrictions on foreign workers through increasing the dependency ratio ceiling, reducing the foreign worker levy or lowering the eligibility criteria for the application of work pass, which will increase the number of foreign workers. It can loosen restrictions on immigrants through lowering the eligibility criteria for the application of citizenship or permanent residence, which will increase the number of immigrants.
1.3.1 Trade Liberalisation
A reduction in tariffs and non-tariff barriers will lead to greater competition which will induce firms to increase labour productivity to reduce costs. To increase labour productivity, firms will adopt better production technologies or engage in research and development and engage in education and training. Adopting better production technologies and research and development will lead to technological advancement which will increase the efficiency of capital in the economy. Education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy.
The Singapore government has been using supply-side policies to increase the production capacity in the economy and hence aggregate supply in order to achieve potential economic growth. As actual economic growth is constrained by potential economic growth, potential economic growth is essential for achieving sustained economic growth. The Singapore government has been using interventionist supply-side policies extensively which include education and training, research and development and infrastructural development. It has also been using market-oriented supply-side policies which include cuts in income taxes and labour market reforms, and to a lesser extent, privatisation and deregulation. In recent years, however, in an attempt to induce firms to increase labour productivity, the Singapore government has been tightening restrictions on foreign workers by decreasing the dependency ratio ceiling, increasing the foreign worker levy and raising the eligibility criteria for the application of work pass. This has led to a slower growth of the labour force resulting in a tighter labour market and hence an upward pressure on wages. Note:   Although supply-side policies are mainly used to increase the production capacity in the economy, many supply-side policies will also lead to a decrease in the cost of production in the economy. For example, education and training will lead to an increase in labour productivity resulting in a fall in the cost of production in the economy. Nevertheless, the main objective of supply-side policies is to increase the production capacity rather than to decrease the cost of production in the economy. In the examination, students are often required to explain how supply-side policies can be used to increase the production capacity in the economy to achieve potential economic growth.
The effect of supply-side policies will fall more on potential output than on actual output. Indeed, if the economy is far from the full-employment equilibrium¸ actual output may not rise, at least not significantly.
1.4 Limitations of Supply-side Policies
The effects of supply-side policies will be realised only in the long run and this long effectiveness time lag makes them ineffective in the short run. For example, it takes time for education and training to increase the skills and knowledge of labour in the economy. Furthermore, although supply-side policies can be used to increase actual output, the effect will fall more on potential output than on actual output. Indeed, if the economy is far from the full-employment equilibrium¸ actual output may not rise, at least not significantly. Therefore, supply-side policies may not be effective for increasing actual economic growth.
2.0 SHORT-TERM SUPPLY-SIDE POLICIES
2.1 Objectives of Short-term Supply-side Policies
Short-term supply-side policies are policies that are used to decrease the cost of production in the economy in the short term and hence increase aggregate supply. As explained earlier, the effects of supply-side policies will be realised only in the long run and this long effectiveness time lag makes them ineffective in the short run. For example, it takes time for education and training to increase the skills and knowledge of labour in the economy. Therefore, supply-side policies are generally not used to deal with a recession. However, unlike supply-side policies, short-term supply-side policies are often used to deal with a recession, as part of a policy mix. In a recession, the government can increase economic growth by using short-term supply-side policies to reduce the cost of production in the economy in the short term. When the cost of production in the economy falls, aggregate supply will rise which will lead to an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.
Short-term supply-side policies are used in Singapore. To increase economic growth in a recession, the Singapore government may reduce the employers’ CPF contribution rate in the short term to decrease the labour cost in the economy. For example, it reduced the employers’ CPF contribution rate from 20 per cent to 10 per cent in the 1997-1998 Asian Financial Crisis. The Singapore government may also help firms pay a certain proportion of wages in the short term to decrease the labour cost in the economy. For example, it implemented the Jobs Credit Scheme which helped firms pay 12 per cent of the wages of a worker up to the first $2500 in the 2008-2009 Global

2.2 Supply-side Effect of Fiscal Policy
Fiscal policy is referred to as a demand-side policy because it is used to influence aggregate demand. However, apart from aggregate demand, fiscal policy may also have an effect on aggregate supply. For example, government expenditure on education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy. Government expenditure on research and development will lead to technological advancement which will increase the efficiency of capital in the economy. Government expenditure on infrastructure will lead to an increase in investment expenditure resulting in a more rapid increase in the quantity of capital in the economy. A decrease in corporate income tax will increase expected after-tax returns on planned investments and hence investment expenditure resulting in a more rapid increase in the quantity of capital in the economy. A decrease in personal income tax will increase after-tax personal income resulting in an increase in the quantity of labour in the economy. An increase in the quantity of capital, the quantity of labour, the efficiency of capital and the skills and knowledge of labour in the economy will lead to an increase in the production capacity in the economy. In addition, an increase in the efficiency of capital and the skills and knowledge of labour in the economy will lead to an increase in labour productivity resulting in a fall in the cost of production in the economy. An increase in the production capacity and a fall in the cost of production in the economy will lead to an increase in aggregate supply. However, when economists talk about fiscal policy, unless otherwise stated, they are normally referring to the use of it to influence aggregate demand.
Fiscal policy has been mainly used for its supply-side effect in Singapore to increase the production capacity in the economy and hence aggregate supply, which is known as fiscal policy with a supply-side intent. For example, the Singapore government spends on education and training which will lead to greater human capital and hence increase the skills and knowledge of labour in the economy. It has set up the Institute of Technical Education, polytechnics and Continuing Education and Training campuses to provide education and training. The Singapore government also spends on research and development which will lead to technological advancement and hence increase the efficiency of capital in the economy.
2.3 Supply-side Effect of Monetary Policy
Monetary policy is referred to as demand-side policy because it is used to influence aggregate demand. However, apart from aggregate demand, monetary policy also has an effect on aggregate supply. Expansionary monetary policy will lead to an increase in investment expenditure resulting in a more rapid increase in the quantity of capital in the economy. Contractionary monetary policy will lead to a decrease in investment expenditure resulting in a less rapid increase in the quantity of capital in the economy. However, when economists talk about monetary policy, unless otherwise stated, they are normally referring to the use of it to influence aggregate demand.