Economics bank

Monetary policy

Markets

Money

Europe

Monetary Policy - Inflation - Cures

Theory 4 - Supply-side policies - supplying less inflation?

The economy can cope with increasing demand if the capacity of the economy grows fast enough. Demand-pull inflation only happens when aggregate demand grows faster than the ability of the economy to produce the goods. Therefore, if we can boost the capacity of the economy we may help to avoid inflationary problems. Supply-side policies are policies that are aimed at doing this. Classical economists argue that these are the main policies necessary, and that the government should not aim to manage the level of demand in the long run. This follows from Say's Law, which says that 'supply creates its own demand'.

Supply-side policies are aimed at making markets work better and removing possible market imperfections. They could include:

• Improved education and training
• Reducing the power of trade unions to increase the flexibility of wage-setting
• Reducing taxes to encourage investment and risk-taking
• Reducing the level of tax to motivate people to work harder
• Removing unnecessary regulations from markets that may hinder efficiency and innovation

The effect of these policies should be to shift the aggregate supply curve to the right. We can see this on the diagram below. The economy clearly has a greater capacity to produce and can cope with a higher level of aggregate demand before there is any increase in the price level.