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Supply-Side Economics in Fiscal and Monetary Policy

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  • 0:09 Stimulating the…
  • 3:21 Examples of…
  • 4:01 Origin of Supply-Side…
  • 5:23 Results of Supply-Side Policy
  • 6:33 Illustrating…
  • 8:18 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

This lesson explains what supply-side economics is, where it started, and how economists illustrate it. It provides a basic overview of the still-controversial theory that was popularized by President Ronald Reagan during the 1980s.

Stimulating the Supply Side of the Economy

In 1980, Ronald Reagan was elected to the office of the President by a landslide. His major campaign promise was to shrink the size of government and lower taxes so businesses could invest and help the economy grow. His tax cut was the largest in history. The highest marginal tax bracket was reduced from 70% to 28%, while the highest tax rate that corporations paid decreased from 48% all the way down to 34%. Reagan also promised to slow the growth of the money supply in order to reduce inflation.

These fiscal and monetary moves are examples of what economists call supply-side policy. For the rest of this lesson, we'll take a look at what supply-side economics is all about, how to recognize it, and which fiscal policy actions are considered to be on the supply side.

Most of the fiscal policy you'll ever hear about in macroeconomics is based on the Keynesian idea of changing aggregate demand in an effort to return the economy to full employment. When the economy falls into recession, the government uses fiscal policy actions to increase aggregate demand, shifting the aggregate demand curve to the right, resulting in greater economic output but also higher inflation.

Just like you can influence aggregate demand to help the economy and increase the number of jobs, you can also increase aggregate supply. In other words, instead of demand-side economics, you can use supply-side economics. Supply-side economics is the viewpoint that the best way to improve economic growth and create jobs is by increasing the production of goods and services. Sometimes referred to as 'trickle-down' economics, it is a viewpoint that lowering taxes and limiting government removes barriers to investment. With fewer barriers like these, it is believed, consumer spending, economic growth, and employment are all greater, with lower inflation.

Supply-siders believe that when businesses do well, they will hire more workers, and the added earnings in workers' pockets will lead to higher consumer demand as well as a stronger economy. Why is increasing consumer demand important? Because consumer spending is the main driver of the economy; it accounts for around 70% of economic growth.

Supply-side policies theoretically lead to an increase in the aggregate supply curve as incentives for suppliers are increased. Supply-siders believe that the incentive to work is kept artificially low because of high taxes but will increase when taxes are reduced. They believe that lower taxes create an incentive for people to work harder, and when they work more, this increases the amount of taxes collected by the government.

Examples of Supply-Side Policies

Policies supported by supply-side economists include:

  • Reducing marginal tax rates
  • Lower tax rates on interest earned from savings
  • Higher tax credits on investment
  • Less government regulation, including the minimum wage
  • Privatizing public industries

Let's look at it from the opposite perspective: Anything that increases the size of government or government regulations would not be a supply-side policy. Anything that increases taxes on savings or personal income would not be considered a supply-side policy.

Origin of Supply-Side Economics

Supply-side economics is an idea that came from economist Arthur Laffer in the 1970s, although we can trace parts of it back to the 18th-century French economist named Jean-Baptiste Say and probably the famous economist Adam Smith as well. Most of the fiscal and monetary policies used today focus exclusively on increasing consumption. But, Jean-Baptiste Say came up with a rather brilliant statement that warns us not to focus an economy entirely on the demand-side. He said this:

'The encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.'

What he was saying is that the government should focus on helping the economy save and produce more, not consume more. The more we produce, the bigger the economic pie is for everyone and the greater the standard of living - that is, if the supply-side policies worked perfectly.

Results of Supply-Side Policy

So, what actually happened after these supply-side efforts were undertaken during the Reagan years? Let's take a quick look. The unemployment rate did decline from 10.8% in 1982 to 5.4% in 1988; GDP growth rose from -0.3% to over 4%. Additionally, inflation declined from 10% all the way down to 4% during Reagan's administration. However, these bright spots in the economy came at a high cost.

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