Evaluate with the use of real-world examples, the claim that effective supply side policy is able to improve the tradeoff between inflation and unemployment. [15 marks]
The relationship between inflation and unemployment is often explained through the Phillips Curve, which suggests an inverse relationship between the two. As seen below, as inflation increases, the unemployment rate goes down. This is because it is assumed that inflationary is caused by increased economic activity which implies more jobs, and thus lower unemployment.
Supply-side policies aim to increase productivity and economic efficiency, theoretically improving the trade-off between inflation and unemployment. However, the effectiveness of such policies is subject to various limitations, including time lags, unintended consequences, and conflicting objectives.
One significant supply-side policy is education and training to improve labor productivity. For example, Germany’s investment in vocational training has successfully created a highly skilled workforce, increasing productivity. Higher productivity allows firms to meet increased demand without raising prices, controlling inflation while lowering unemployment. This can be seen in the diagram below where AD and AS shift outwards owing to the fiscal and supply-side nature of this policy. As a result, there is minimal inflationary pressure but a significant increase in real GDP, suggesting an reduction in unemployment as there would be more economic activity.
However, the impact of such policies can be slow, with benefits taking years or even decades to materialize. Training programs require substantial investment, and the skills mismatch in rapidly changing industries could mean that training today may not meet future demand. Additionally, increased labor productivity may lead to structural unemployment, as automation or skilled workers displace lower-skilled workers, worsening the unemployment-inflation trade-off in the short term.
Another supply-side policy is deregulation, such as the reforms pursued by Margaret Thatcher in the UK during the 1980s. By removing barriers to entry and operation, deregulation can enhance competition and efficiency, reducing costs for firms and potentially lowering prices while encouraging job creation. This can be shown on our Phillips curve where lower production costs would shift the SRPC inwards and the long term impact on increasing productive potential would shift LRPC inwards. Thus we can see that the tradeoff is improved as both the inflation rate and unemployment rate are lower at IR1 and NRU2.
However, deregulation can also lead to negative externalities, such as poor working conditions or environmental degradation. It may also contribute to income inequality, as the benefits of deregulation tend to favor capital owners over labor. This inequality can stifle consumption and aggregate demand, limiting its ability to improve the unemployment-inflation trade-off in the long run.
Tax cuts are another example of supply-side policy. The 2017 corporate tax cuts in the U.S. aimed to stimulate investment and job creation, and unemployment did fall to historically low levels. Theoretically, lower taxes give businesses more capital to invest in growth, leading to increased employment and productivity, which should lower inflationary pressures.
However, the magnitude of the tax cut might not be enough to significantly improve the trade-off if businesses choose to use the extra capital for stock buybacks or dividend payments instead of investing in productivity. Moreover, tax cuts can increase fiscal deficits, putting upward pressure on inflation in the long term due to increased government borrowing.
While supply-side policies like education, deregulation, and tax cuts have potential to improve the trade-off between inflation and unemployment, their effectiveness is not guaranteed. Time lags and the mismatch between skills training and market demands can limit the impact of education policies. Deregulation, while boosting competition, can lead to inequality and other unintended consequences. Finally, tax cuts may not lead to sufficient investment to improve productivity and can create inflationary pressures if not well-targeted. Ultimately, the claim that supply-side policies always improve this trade-off depends on their design, the specific context in which they are applied, and the assumptions behind their implementation.