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Advantages and disadvantages of policies

Strengths and weaknesses of fiscal, monetary and supply-side policies

Fiscal policy - strengths

If the problem is one of unemployment, changes in taxation and particularly government spending may have a significant impact on the level of national income through the increase in aggregate demand that they cause. Fiscal policy therefore may be very effective in reducing demand-deficient unemployment. (N.B. For HL students only, the effectiveness of fiscal policy in combating unemployment may be explained through the operation of the multiplier effect. This is dealt with in the HL extension section that follows).

Fiscal policy may also succeed in shifting the LRAS curve to the right, increasing real output and reducing the rate of inflation. This may work via greater government spending on education and training and tax cuts which improve incentives to work and invest.

As will be seen in Section 3.6, fiscal policy may be used to alter the distribution of income and wealth within an economy. Greater emphasis on direct, progressive taxes and benefits to the less well off make the distribution more equal. The opposite effect will be achieved through a shift towards indirect, regressive taxes and cuts in benefits for the less well off.

Section 2 of the course showed how fiscal policy can be used in a selective way, for example, to:

  • Increase consumption of merit goods through subsidies and direct government provision
  • Decrease consumption of demerit goods and imports through taxation
  • Increase consumption of public goods

Fiscal policy - weaknesses

Inflexibility - changes in direct taxes may take considerable time to implement and government spending is often inflexible in a downwards direction; e.g. for political or moral reasons, it is usually difficult to reduce government spending on pensions and benefits and once a capital project such as a motorway has been started, it is difficult, if not impossible, to stop it in mid-stream.

Conflicts between objectives - fiscal policy designed to achieve one goal may adversely impact on another. For example, reflationary fiscal policy designed to stimulate AD and reduce unemployment may worsen inflation (N.B. for HL students only, this is explained in greater detail in the extension section on the long run Phillips curve).

Supply side economists believe that certain fiscal measures will have a disincentive effect. For example, an increase in income tax may adversely affect the supply of labour, an increase in profits tax may adversely affect the incentives of firms to invest and an increase in welfare benefits may adversely affect incentives to seek employment.

Monetary policy - strengths

The main policy instrument of monetary policy at present is the rate of interest and this offers considerable flexibility. The rate of interest may be changed at short notice and regular intervals and may have a significant impact on short-term economic activity. In particular, it has been found to be relatively effective at controlling inflation.

The other aspects of monetary policy, changes in the money supply and exchange rate, may also exert a considerable influence on the level of aggregate demand. Much attention, in response to the credit crunch, has recently been focused on Quantitive Easing. This is a method of increasing the supply of money (sometimes called 'printing money') by increasing the liquidity of the commercial banks. This is achieved by the central bank buying government and other securities from the banks which provides them with cash which could be used to increase their lending. An increase in lending would subsequently increase economic activity in the economy.

Monetary policy - weaknesses

Time lags - it may take considerable time, perhaps up to 18 months, for monetary policy measures to influence aggregate demand. For example, a change in the rate of interest is unlikely to immediately influence consumption and investment plans.

Conflict between policies - a rise in the rate of interest, for example, designed to reduce inflation may lead to increased unemployment.

Discriminatory impact - a rise in interest rates may increase business costs (it raises the cost of borrowing) and increase the exchange rate (it increases the demand for the currency) thus making exports more expensive. Such a rise may therefore particularly discriminate against manufacturing organisations engaged in exporting, as well as borrowers in general.

Limited scope for change in reality - in practice, if one country's interest rates get too much out of line with those of other countries, there will be considerable inflows or outflows of funds. In addition, countries which are part of a monetary union, for example the European Monetary Union, have their interest rates dictated to them by the European Central Bank and are not free to alter their interest rates independently.

Supply-side policies - strengths

Supply-side policies may be targeted at particular sections of the economy raising efficiency there. Successful application for the economy as a whole will shift the LRAS to the right, increasing the level of real output and lowering the price level.

Achievement of the major macro-economic goals of economic policy - these may be achieved if LRAS is shifted to the right. Such a shift:

  • Represents an increase in the productive potential of the economy (economic growth)
  • Will lower the price level (thus helping to reduce inflation)
  • Will increase the level of real output and, more than likely, the level of employment as the two are closely correlated.
  • Will help to improve the balance of payments if the improved efficiency represented by greater LRAS transmits itself through to increased competitiveness for firms engaged in exporting.

Supply-side policies - weaknesses

Supply-side policies have been largely associated with neo-classical, free market or supply-side economists, and there is considerable disagreement between such economists and economists who favour an interventionist approach as to how best the economy should be managed.

Some interventionist objections to particular supply-side policies are as follows:

  • Education and training - few would disagree with the wisdom of committing government spending to these areas, but such expenditure may be insufficient in itself to guarantee permanent jobs without ensuring an adequate level of aggregate demand in the economy; in supply-side policies they need to be accompanied by appropriate fiscal and/or monetary policies.
  • Reduction in unemployment benefits - apart from the economic objection that such a policy would lower the spending power of such recipients and therefore reduce aggregate demand, output and employment, such a policy can be questioned on moral and political grounds. Is it right to make a group of people who are likely to be amongst the poorest in society, even poorer, while at the same time making the rich richer through tax cuts? Moreover, the idea that 'taking a stick' to the unemployed to force them back to work, presupposes that all unemployment is of a voluntary nature. In practice, people may be involuntarily unemployed because of lack of demand in the economy or because there is a lack of employment opportunities in the particular regions of the economy in which they find themselves.
  • Reduction in direct taxes - while the poor are given the 'stick' to improve their incentives (via cuts in welfare benefits), the better off are given the 'carrot' in the form of tax cuts. Apart from the morality of such policies which make life more unpleasant for the least fortunate and make society more unequal, the alleged incentive effects of lower taxes have little empirical basis. A number of studies have shown that cutting income tax does not make people work harder and longer. Apart from people in reality often being unaware of their marginal tax rate, it has been found that lower taxes may encourage some workers to take more leisure time as they can now gain the same disposable income by working less hours.
  • Reduction in the power of trade unions - for those economists who are not of the free market persuasion, this is simply viewed as another measure to shift wealth, income and the balance of power away from the less well off to the better off. The individual employee is always weaker than the individual employer, especially where the employer is a large multinational corporation, and trade unions act as a counterbalance to those unequal power relations. Trade unions may also actually reduce the firm's costs by acting as a channel for communication between employers and employees - it is likely to be cheaper for the firm to negotiate with one organisation rather than with each employee individually.
  • Deregulation - over recent years the world financial system has been largely deregulated with a 'free' market being largely established. It is this lack of regulation that has widely been blamed for the recent credit crunch and the world - wide economic crisis that followed. It is only the subsequent government intervention, most notably in the U.I.A. in the form of nationalisation and re-regulation that avoided total economic melt-down!
  • Privatisation - this has been at the heart of supply-side, free market economies since the early 1980s and has been a central component of the structural adjustment programmes imposed on less developed countries by the IMF and the World Bank. Click on QUOTES to get a flavour of the degree of opposition privatisation has caused.

In particular, privatisation has been criticised on the following grounds:

  • Political arguments - for those who believe that socialism represents a superior form of society to capitalism, the movement towards privatisation of the means of production would be one that was in the wrong direction, and one which would inevitably lead to greater class conflict, greater exploitation of workers and a more unequal and unfair society in general.
  • Management of the economy - a privatised laissez-faire economy, as opposed to one with varying degrees of government control, is likely to be particularly prone to the vagaries of the market, the violent swings of the trade cycle and the movement in an out of the country of speculative capital flows.
  • Natural monopolies - the case against the privatisation of utility industries such as gas, water and electricity rests upon the enormous potential for private monopoly abuse in terms of high prices, poor quality service for consumers, worsened conditions and redundancies for employees, with high dividends for shareholders and high salaries for senior managers (the 'fat cat' syndrome).
  • Fraud - while claiming that 'popular capitalism' has returned industries to the public, the opposite has been the case. When an industry is nationalised, it is jointly owned by everyone in the country. Privatisation therefore represents a process of selling shares or assets to people who may already own those assets, a confidence trick which if carried out by any individual would carry a stiff custodial sentence! At the same time, those individuals who are either unable or unwilling to purchase the shares are in effect compelled to relinquish their assets.
  • Deregulation - this has also been a central plank of supply-side policy and its advantages are based on the general arguments for a freely operating price system (the promotion of competition and enterprise, greater efficiency, lower prices and wider choice for consumers, 'getting the state of the backs' of businesses by the removal of 'red tape' and bureaucracy). However, like privatisation, it has been fiercely criticised. Follow the criticisms of deregulation link to see these.