Fiscal, Monetary and Supply-Side Policy: Question 9

Worked solution

Part (a): Classifying the three options

• Option (i), an increase in public spending on unemployment benefits and public-sector wages, is fiscal policy, since it involves a change in government spending (G).
• Option (ii), cutting the central bank’s policy interest rate, is monetary policy, since interest rates are a monetary policy tool.
• Option (iii), deregulation to encourage new business start-ups, is supply-side policy, since it aims to raise Vantoria’s productive capacity by making it easier for entrepreneurs to establish new firms, rather than by directly changing G, T or interest rates.

Part (b): Why (i) and (ii) reduce unemployment more quickly

Options (i) and (ii) both work by raising Aggregate Demand directly. The extra public spending in (i) adds straight to the G component of AD, and the interest rate cut in (ii) lowers the cost of borrowing, encouraging higher consumption (C) and investment (I). Using AD/AS analysis, both changes shift the AD curve to the right along Vantoria’s existing AS/LRAS curve, which, given some spare capacity from the recession, raises real output and employment fairly soon after the policy is put in place, reducing cyclical unemployment.

Option (iii), by contrast, does not shift AD directly at all. It is intended to shift LRAS itself to the right, but this can only happen once entrepreneurs actually respond to the lighter licensing requirements by setting up new businesses, hiring staff, and expanding production. A process of business formation and growth that takes considerably longer than an immediate change in G or in interest rates. So while (i) and (ii) can affect unemployment within a relatively short time, (iii) works through a much slower channel.

Part (c): Discussing the long-term case for deregulation

There is a reasonable case that option (iii) could be the more effective long-term solution. New businesses created as a result of deregulation add permanently to Vantoria’s productive capacity and its ability to create jobs, without requiring the government to keep running budget deficits (as sustained use of option (i) would, adding to the national debt) or keep interest rates low indefinitely (which option (ii) cannot do once rates approach zero, and which can also encourage excessive borrowing). If deregulation succeeds, the resulting fall in structural unemployment could be more durable than a fall in cyclical unemployment achieved purely by boosting demand.

However, this case has real limits. Deregulation’s success is less certain. It depends on entrepreneurs actually being willing and able to start new businesses, which also requires access to finance, market demand and business skills that removing licensing requirements alone cannot guarantee. Meanwhile, options (i) and (ii) offer much faster relief to workers who are unemployed right now, which matters both economically and socially. Overall, the most reasonable judgement is that demand-side policies such as (i) and (ii) are better suited to addressing the immediate rise in cyclical unemployment from the downturn, while supply-side deregulation such as (iii) is a valuable complementary policy for reducing unemployment more permanently over the longer run, rather than a substitute for short-run demand management.

Final answers

• (a) (i) fiscal policy; (ii) monetary policy; (iii) supply-side policy
• (b) (i) and (ii) shift AD along the existing AS/LRAS curve almost immediately; (iii) requires LRAS itself to shift, which takes much longer as new businesses are created
• (c) Deregulation may give a more durable, debt-free long-term reduction in unemployment, but is less certain and slower than (i)/(ii), so demand-side policy suits the short-run downturn while supply-side policy complements it over the longer run