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Fiscal, Monetary and Supply-Side Policy: Question 10

Syllabus 5.1, 5.4

Multiple choice AS 1 mark

Which of the following is the best example of a supply-side fiscal policy measure, rather than a purely demand-side fiscal policy measure?

Choose an answer to check it, then compare with the worked solution below.
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Worked solution

Step 1: Identify what makes a fiscal measure “supply-side”

Fiscal policy always involves government spending or taxation, but it can be used for two different purposes. Most fiscal measures are demand-side: they are designed to shift Aggregate Demand (AD), typically to smooth out short-run fluctuations in output and employment. A smaller set of fiscal measures are supply-side: they use taxation or spending specifically to raise the economy’s long-run productive capacity, shifting long-run aggregate supply (LRAS), by changing firms’ or workers’ incentives to invest, work or innovate.

Step 2: Evaluate each option

  • Option A, a temporary income tax cut to boost consumer spending, is designed to raise consumption and shift AD to the right during a downturn. This is a demand-side fiscal measure.
  • Option B, a permanent tax credit rewarding firms specifically for investing in new machinery and staff training, is designed to raise firms’ capital stock and workers’ skills, which increases the economy’s underlying capacity to produce. This directly targets LRAS, making it a supply-side fiscal measure.
  • Option C, extra spending on unemployment benefits during a downturn, raises G in order to support AD during a recession. This is also a demand-side fiscal measure.
  • Option D, a cut in the central bank’s interest rate, is not a fiscal measure at all; it is a tool of monetary policy.

Step 3: Select the best answer

Only option B is both a fiscal policy tool (it works through the tax system) and aimed at raising long-run productive capacity rather than smoothing short-run demand, which is exactly what defines a supply-side fiscal policy measure.

Final answer

Option B. A permanent tax credit for firms that invest in new machinery and staff training. It is a tax-based (fiscal) measure explicitly designed to raise long-run productive capacity by shifting LRAS, distinguishing it from the purely demand-side fiscal measures in A and C and from the monetary policy tool in D.