Keynesian and Neo-Classical Supply Side Policies for Long-Term Economic Growth

This assignment analyzes how the government uses Keynesian and neo-classical supply side policies to achieve long-term economic growth. It discusses the significance of supply side policies, Keynesian growth framework, and ways by which government can use Keynesian and neo-classical supply side policies to achieve long-term growth. Examples of such policies used by European governments are also discussed.

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Introduction
The purpose of this assignment is to analyze how the government uses Keynesian and
neo-classical supply side policies to achieve long-term economic growth. Neo- classical or
supply side economics refers to the macroeconomic theory that argues economic growth can be
created effectively by reducing taxes as well as reducing deregulation. According to neo-
classical supply side economics, the consumers might benefit from larger supply of products and
services at low price as well as increase in employment rate. This theory states that enhanced
production enhances economic growth. Neo- classical supply side policies is the contrast of
Keynesian theory, which defines that demand is one of the main driving force (Taussig 2013).
The reason behind why supply- side growth theory might appear to give an alternative to Keynes
as this theory helps to interpret as that of demand management. The supply side attack on the
Keynesian policies is mainly based on return to growth analysis that is put forward by classical
economists and then rediscovered by Harrod, Solow. Neo-classical economists believe in fiscal
policy approach that is designed in promoting economic growth with the stable prices. The study
also focuses on the Keynesian growth framework that provides the long- term growth theory,
which builds upon Keynesian approach to the economic fluctuations. The examples of such
policies that are used by any European government is also discussed in this study.
Discussion
Neo- classical supply side policies and its significance
The major assumption of the Neo- classical economics is that the supply side factors
determines the real output. Neo- classical economists mainly argue that the supply side factors
mainly influences growth of real output as well as productive capacity (Borio 2014). Several
economists pointed out that long-term economic growth can be achieved by the integration of

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supply side policies. The supply side policies refers to the government policies that seek to
enhance efficiency as well as productivity of the nation. This includes- free market and
interventionists supply side policies. The government of a specific nation has some
macroeconomic objectives, such as-
 Low inflation
 Low unemployment
 Equilibrium on BOP( balance of payments)
 Higher or long term economic growth
Evans and Honkapohja (2012) opines that often the conflict occurs among these
macroeconomic objectives. For instance, expansionary fiscal policy imposed by the government
might contribute to high economic growth as well as lower unemployment. Therefore, this would
be at inflation cost and deterioration on current account. Tinkler and Woods (2013) suggests that
it is vital to enhance an economy’s supply side in order to attain all macroeconomic objectives
simultaneously. If government enhances productivity as well as shifts aggregate supply (AS) to
right, then it might improve competitiveness and enable low growth in inflation of that economy.
Neo classical economists argues that long run aggregate supply is inelastic and rise in AD is
inflationary and hence do not impact real output level. One of the major limitations for
enhancing long run economic growth rate is the productivity growth. Mankiw (2014) cites that
trend rate of long run growth cannot be increased through the demand- side policies. However, if
government needs higher sustainable economic growth rate, then it needs effectual supply side
policies that increases the productivity. For instance,

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Proper training schemes that provide laborers more skills might lead to higher productivity of
labour. Governments should try as well as motivate entities to make investment in research and
development (R&D) by providing tax credits. Thus, these effective policies might enable higher
economic growth of the nations. Thus, supply side policies increases long run aggregate supply
(LRAS), which in turn enhances potential growth. In practice, the government faces difficulties
to impose supply side policies in order to achieve long run economic growth. This is because the
productivity growth mainly depends on technological improvements to huge extent but these
improvements becomes independent on government policies.
Figure 1: supply side policies shifting LRAS to right and allowing higher growth
Source: (Economicshelp.org. 2018)
Supply side policies influencing unemployment
Rios, McConnell and Brue (2013) states that supply side policies has huge significance in
decreasing natural unemployment rate. The natural unemployment rate involves structural as
well as frictional unemployment, which are also known as supply side unemployment. In fact,

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supply – side policies might not solve unemployment that occurs due to insufficient economic
growth. This has been seen during recessionary period when there is rise in unemployment as
entities lay off laborers. However, the government might face difficulties in solving
unemployment through their supply side policies and thus higher growth is required (Sloman,
Norris and Garrett 2013).
Supply side policies and inflation
For attaining low inflation, the supply side policies might aid to decrease cost as well
enhance productivity. One of the most important factors in controlling inflation arte within the
economy is utilization of monetary policy as well as controlling AD through rate of interest.
Moreover, the supply side policies might take longer time to have huge impact on decreasing
inflationary pressures.
Figure 2: Low cost- push inflation
Source: (Economicshelp.org. 2018)
Supply side policies influencing BOP

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Rise in productivity due to supply side policies can aid the BOP. If the entities become
highly competitive, then UK products will be in huge demand. This in turn will increase exports
as well as improve current account deficit. The supply side policies that are vital for the
exporters will be transport quality. For example, declining congestion as well as supply
bottlenecks might aid to reduce business cost. Overall, several neo classical economists argue
that supply side policies might be beneficial along with limited drawbacks. Therefore, the
government of the specific nation faces difficulties to enhance productivity and thus demand side
policies or Keynesian policies is mainly used during the recessionary period. This can help to
increase AD in the recession, thereby shifting LRAS rightward can have limited impact in
solving macro-economic issues.
Figure 3: use of demand side policies to increase AD
Source; (Economicshelp.org. 2018)
Keynesian framework of long- term growth
The Keynesian growth model is the framework that aids to reconcile two paradigms,
which involves- fluctuations around exogenous as well as stable growth path and determinants of

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the trend growth mainly abstracting from fluctuations of business cycle. This model is referred to
as Keynesian Growth model as it provides long- run growth theory, which builds upon the
Keynesian approach to fluctuations of the economy. In addition to this, this theory mainly brings
together Keynesian insight that the nation’s unemployment might occur from weak aggregate
demand with basic notion that the growth in productivity is the outcome of investment done by
the profit maximizing entities in innovation. In this framework, there are mainly two kinds of
agents such as- entities and households. The entities total investment in innovation mainly
determines productivity growth rate as well as potential output of the economy. In Keynesian
analysis, the nominal wages are rigid partially. This friction infers that there is a possibility of
unemployment owing to weak aggregate demand and that the monetary policy might influence
real economy.
In Keynesian growth model, the fluctuations in business cycle can have huge influence
on growth in productivity and investment in innovation (Reisman 2013). Apart from this,
monetary policy adopted by the policymakers can also affect the entity’s investment as well as
productivity growth. Thus, this framework allows huge analysis of interactions between
monetary policy, productivity growth and economic fluctuations.
Effect of stabilization policies on long – term growth
The Keynesian growth framework highlights that the productivity growth and aggregate
demand (AD) are directly related by two- way interaction.
Firstly, the productivity growth withstands AD as well as aids monetary policy for
stabilizing the economy. In this framework, the household demand for total consumption mainly
depends on future income expectations. For instance, slowdown in potential output growth rate is

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connected with low future income as well as decrease in present AD. Furthermore, if AD is not
strong, it is likely that the monetary policy might be constrained by zero lower bound, thereby
restricting central bank of the nation from stabilizing the respective economy (Laibson and List
2015). Therefore, healthy growth in productivity plays vital role in enduring AD as well as
aiding stabilization of the economy through the monetary policy.
Secondly, huge demand also increases growth of productivity. In this model, the entities
makes investment in innovation for gaining monopoly position. Thus, the total investment in
innovation becomes directly related to firm’s profits. Moreover, slowdown in AD leading to
decline in profits also decreases entity’s investment in those activities that enhances productivity.
This impact signifies that maintaining full employment in the economy creates environment that
is favorable to entities investment as well as productivity growth (Heijdra 2017).
Thus, this framework recommends that robust AD, high growth and resilience of
economy to the business cycle shocks might be complementary (Arena 2016). In addition to this,
this also suggests that there are some synergies between the supply- side policies and
stabilization policies. Effective management of AD is vital to foster entities investment as well as
productivity growth. On the contrary, policies relating to pro- growth supply-side enhances AD
and decreases probability that monetary policy might be constrained by zero lower bound. The
Keynesian growth model recommends that the nation’s central bank must assure that economy
operates at the full employment in order to increase productivity growth. Hence, the Keynesian
growth framework helps to analyze about conducting the policy in low- growth environment.
Ways by which government can use Keynesian and neo- classical supply side policies to achieve
long-term growth

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The government of the particular nation can use Keynesian and neo- classical supply side
policies in several ways for achieving long- term economic growth. The government policies for
enhancing long – term growth are mainly focused to increase AD through Keynesian demand-
side policies or enhance AS through neo- classical supply-side policies. The Keynesian demand
side policies involve-
 Fiscal policy ( through reducing taxes or enhancing government spending)
 Monetary policy( reducing interest rates)
On the other hand, the neo-classical supply side policies involve-
 Free market supply side policies such as- Privatization, tax cuts, deregulation, free trade
agreements
 Interventionist supply side policies such as- improved infrastructure, improved education
as well as training.
Keynesian demand side policies play a vital role in enhancing long-term economic growth if
there occurs negative output gap (Crafts and Mills 2013). Monetary policy is one of the common
tools used by the government or central bank to influence economic activity. The policymakers
can reduce interest rate for boosting AD. This low interest rate declines borrowing cost and
motivates investment as well as consumer spending. It also decreases mortgage payments and
enhances consumers disposable income. As a result, this helps the government to achieve long-
term economic growth. In few circumstances, this policy might be ineffective to boost economic
growth.
The government can also enhance demand by reducing tax as well as increasing government
expenditure. Low tax can increase consumers disposable income as well as motivate consumer

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spending. Higher government expenditure can create jobs as well as give economic stimulus.
Thus, this can aid the policy makers to attain long term economic growth by implementing fiscal
policies. In few cases, the government can use such policies to limit aggregate demand growth.
Therefore, it is vital to avoid economic boom where growth proves inflationary as well as
unsustainable. One of the issues with expansionary fiscal policy is that it increases the
government borrowing. However, for financing extra spending, government usually have to lend
from private sector. Moreover, if the nation is growing, then government borrowing might crowd
out private sector.
Figure 4: Demand side policies
Source: (Economicshelp.org. 2018)
Another strategy that the government can use to improve long-term economic growth is
adoption of supply side policies. Such policies involve-
Free market supply- side policies

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Reducing income taxes- Canto, Joines and Laffer (2014) argues that lower taxes increase
the people’s incentives to work much harder, thereby leading to rise in supply of labor and
output. This leads to increase in economic growth.
Flexible labor market- The government adopting policies in increasing flexibility in labor
market can provide long- term increase in investment, which in turn can aid them to achieve long
term growth. In certain cases, excessive regulation in labor market might discourage entities to
employ laborers in their job.
Better relationships among trade unions- Crafts and Mills (2013) found out that decrease
in power of the trade unions can aid to increase labor productivity. Moreover, it also declines real
wage unemployment.
Interventionist supply-side policies
Increasing education as well as training- Burda and Wyplosz (2013) states better
education helps to enhance labor productivity as well as increase AS. As education provision in
free market leads to market failure, the government can subsidies proper education as well as
training schemes.
Improving infrastructure as well as transport-The government expenditure on transport
can aid to reduce congestion as well as overcome market failure. It also aids to decrease transport
cost and motivate entities to make investment.
Improving healthcare- The business might face huge loss due to ill- health. The government
can increase their expenditure on health care in order to improve labor productivity. In some
cases. Such supply –side policies might be counter- productive (Taussig 2013).

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Examples of such policies used by the UK government
Some of the examples of these two policies used by UK government are described below-
 During the recession in the year 2009, the UK government had lowered interest rate to
0.5%, but expenditure remained subdued. Even the banks in this nation were unwilling to
lend money to the people due to shortage of liquidity. As a result, this policy became
ineffective to achieve long term growth.
 Recent evidences reflect that in the year 2009-2010, as the UK government implemented
expansionary fiscal policy, it increased the UK government borrowing, Thus, the UK
government had to lend from private sector in order to attain long term growth. This is
shown in the chart given below (Burda and Wyplosz 2013)-
Figure 5: Increase in UK government borrowing due to adoption of expansionary fiscal policy
Source: (Economicshelp.org. 2018)

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 The graph below reflects that Eurozone had required effective supply side policies for
reducing unemployment rate that rose rapidly during the recession. However, during this
period, the UK government implemented policy of enhancing flexibility in labor market.
This in turn made the firms easier to hire laborers, make investment and employ laborers.
This in turn provided boost to investment and economic growth for long- term.
Figure 6: Unemployment rate in European countries over the years
Source: (Economicshelp.org. 2018)
 As the UK economy suffered due to poor industrial relations, it hampered their economic
growth. For this reason, the UK government adopted supply side policies by improving
the union relationships in order to achieve long-term growth.

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Conclusion
From the above discussion, it can be concluded that both Keynesian demand side policies
as well as neo- classical supply side policies play vital role in enhancing the growth of the
economy. Although both these policies has certain limitations, most of the European government
implemented these two policies in order to increase productivity growth as well as enhance long-
term growth rate. One of the European countries such as in UK, the implementation of these two
policies helped the nation to recover recessionary period and achieve higher economic growth.

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