AQA Specification focus:
‘How supply-side policies can affect unemployment, the rate of change of prices and UK external performance, as reflected in the balance of payments on current account.’
Supply-side policies influence the long-term productive capacity of the economy. Their impacts are felt through changes in unemployment, inflationary pressures, and the UK’s international trade performance.
Supply-Side Policies and Unemployment
Labour Market Reforms
Supply-side measures aim to increase labour market flexibility, reduce structural barriers, and lower the natural rate of unemployment. This is achieved through:
Education and training initiatives to improve skills and employability.
Welfare-to-work programmes encouraging participation in the labour force.
Labour mobility reforms, such as relocation support and streamlined job-matching services.
Natural Rate of Unemployment: The level of unemployment consistent with stable inflation, reflecting frictional and structural unemployment rather than cyclical factors.
These policies reduce long-term joblessness by addressing mismatches between workers’ skills and the demands of the economy. For example, investment in vocational education increases the adaptability of the workforce.
Incentive Effects
Tax reforms lowering marginal rates can encourage individuals to seek work or work longer hours.
Reduced benefits dependency through targeted welfare reform increases labour supply.
Supply-side interventions therefore aim to shift the long-run aggregate supply (LRAS) curve outwards, supporting higher employment at stable price levels.
Supply-Side Policies and Prices
Impact on Inflation
By raising productive capacity, supply-side policies can reduce cost-push inflationary pressures and increase non-inflationary growth. When LRAS shifts outward:
Firms can produce more without raising prices.
Competition-driven efficiency keeps costs lower.
Productivity improvements reduce unit labour costs.
Non-inflationary Growth: An increase in real GDP that does not cause upward pressure on the general price level.
In the Keynesian zone, AD largely determines the quantity of output.
This graph shows the Keynesian, Intermediate, and Neoclassical zones of the Aggregate Supply curve. It illustrates how shifts in AD and AS affect output and prices differently in each zone. Source
Deregulation and Market Liberalisation
Deregulation enhances competition, preventing monopolistic price rises.
Privatisation introduces profit incentives, leading to efficiency gains that can translate into lower consumer prices.
However, the impact depends on the effectiveness of reforms. For instance, if deregulation reduces oversight excessively, short-term price instability may occur.
Supply-Side Policies and External Performance
Competitiveness in Global Markets
Policies that improve productivity and efficiency also enhance international competitiveness. Lower production costs allow UK firms to export goods at more competitive prices, supporting the balance of payments.
Balance of Payments on Current Account: A record of trade in goods and services, investment income, and current transfers between a country and the rest of the world.
Exchange Rate Considerations
Higher competitiveness can strengthen export performance without relying on currency depreciation.
By improving quality and innovation, UK goods gain a sustainable edge in global markets.
Structural Improvements
Investment in research and development (R&D) fosters innovation, creating high-value exports.
Infrastructure spending supports logistics and reduces costs for exporters.
Training and education build a skilled workforce, attracting foreign direct investment.
Interconnected Effects
Unemployment and Prices
Reduced unemployment from successful supply-side measures lowers benefit payments and increases tax revenues. This boosts fiscal sustainability without generating demand-pull inflation, provided LRAS expands simultaneously.
Prices and External Performance
If productivity grows, domestic goods become cheaper relative to imports, improving the trade balance. Conversely, failure to control wage pressures may erode competitiveness.
Long-Term Growth Potential
Supply-side policies increase the trend rate of growth, ensuring that the economy can expand sustainably. By doing so, they improve resilience to global shocks and reinforce macroeconomic stability.
Labour Productivity (Output per Worker) = Total Output ÷ Number of Workers
Total Output = Value of goods and services produced
Number of Workers = Total employed labour force
A Phillips curve illustrates a tradeoff between the unemployment rate and the inflation rate.
The Short-Run Phillips Curve illustrates the inverse relationship between unemployment and inflation. It highlights the trade-off policymakers face when implementing supply-side policies. Source
Sustained improvements in productivity drive competitiveness and underpin favourable performance in unemployment, inflation, and trade simultaneously.
Evaluation of Effectiveness
Strengths
Reduce structural unemployment permanently.
Promote sustainable, non-inflationary growth.
Improve trade balance through enhanced competitiveness.
Limitations
Time lags: Education and training take years to affect labour market outcomes.
Costly interventions: Government spending on R&D and infrastructure increases fiscal pressures.
Global factors: Exchange rates and foreign demand also influence external performance, limiting domestic policy control.
Overall, supply-side policies are essential for addressing unemployment, stabilising prices, and supporting the UK’s external balance, but their effectiveness relies on implementation, funding, and global economic conditions.
FAQ
In the short run, supply-side policies may have little immediate impact, as training programmes and infrastructure investments take time to influence the labour market.
In the long run, however, these measures reduce structural unemployment by equipping workers with relevant skills, improving labour mobility, and enhancing overall productivity. This leads to a sustained fall in the natural rate of unemployment.
Demand-side policies often focus on controlling aggregate demand, which can reduce inflation but may slow growth.
Supply-side policies expand productive capacity by lowering unit costs and increasing efficiency. This helps firms meet demand without raising prices, making them more effective in addressing inflation caused by rising wages or resource costs.
Innovation raises the quality and uniqueness of exports, allowing UK firms to compete beyond price.
Supply-side policies supporting research and development encourage new products, processes, and technologies. This creates comparative advantage in high-value sectors, boosting export revenues and reducing reliance on imports.
By increasing productivity and reducing production costs, supply-side policies can make UK exports cheaper relative to imports.
If demand for exports is price elastic, the UK gains from selling more abroad.
However, if global demand is inelastic, lower export prices may worsen the terms of trade despite higher volumes.
The benefits of policies such as education reform, training programmes, or infrastructure investment are not immediate.
Education can take a generation to show results.
Infrastructure projects often require years of planning and completion.
R&D subsidies may only produce innovations in the long term.
This delay can make supply-side policies politically less attractive compared to demand-side interventions with quicker results.
Practice Questions
Define the term “non-inflationary growth” and explain briefly how a supply-side policy might help achieve it. (2 marks)
1 mark for correct definition of non-inflationary growth: growth in real GDP without causing upward pressure on the general price level.
1 mark for a clear example of a supply-side policy that enables it, e.g. investment in education/training, deregulation, or infrastructure investment that shifts LRAS outwards.
Explain how supply-side policies can improve the UK’s balance of payments position on the current account. (6 marks)
1–2 marks: Basic explanation that supply-side policies can improve productivity and competitiveness.
2–3 marks: Clear link to exports being more competitive internationally (lower costs or improved quality) and imports being substituted by domestic production.
1–2 marks: Application to the UK, e.g. policies such as investment in R&D, education and training, or infrastructure development making UK exports more attractive.
Up to 6 marks total: Maximum marks awarded for a coherent, well-developed explanation with accurate economic terminology and explicit reference to the balance of payments on the current account.
