Fiscal and monetary policy boost demand in the short run; supply-side policy raises capacity in the long run.
Fiscal policy: lower taxes or more government spending raise total demand. This helps when there are idle workers and machines, as in a recession. Spending on roads and ports also lets the economy make more in future.
Monetary policy: lower interest rates make loans cheaper, so people spend more and firms buy more machines. A lower exchange rate makes exports cheaper, so foreign buyers want more.
Supply-side policy: schools, training, better transport and reasons to invest give the economy more and better resources. The PPC shifts outwards, so growth can last.
Which works best depends on the situation. Policies that raise demand act faster. But if there are few idle resources, they mostly push up prices. Supply-side policies give lasting growth, but they are slow and cost a lot.
- Short run
- Fiscal and monetary policy boost demand.
- Long run
- Supply-side policy raises capacity.
- Depends on
- Spare capacity, time, cost, inflation risk.
Worked example: Choosing a policy for the situation
Compare two economies.
- Economy A is in a recession with high unemployment: a cut in interest rates or more government spending can quickly raise demand and output.
- Economy B is near full employment but growing slowly: more demand would mainly raise prices.
- Economy B needs supply-side policy, such as training and investment in technology, to raise capacity.
Watch out for this
Increasing demand always raises growth.
If the economy is already near full capacity, more demand mainly raises prices. Growth then needs more or better resources.
Check your understanding
An economy is at full employment but wants faster growth. Which policy is most suitable?
- Supply-side policy to raise productive capacity
- Cutting interest rates to boost demand
- Raising taxes