Supply Side Economics

The problem of stagflation encountered by USA and UK during the seventies and early eighties when both high inflation and high unemployment prevailed simultaneously did not admit for easy solution through the Keynesian demand management policies, it only worsened the situation.

Against this backdrop, the alternative school of thought, about macroeconomics laid stress on Supply Side of macroeconomic equilibrium, that is, it focused on shift in the aggregate supply curve to the right rather than causing the shift in the aggregate demand curve. Thus Supply side economics prefers to solve the problem of stagflation through the management of aggregate Supply rather than the management of aggregate demand. Further Supply Sides economics stresses the determinants of long run growth instead of causes of short run cyclical movement in the economy. Supply Side economists laid emphasis on the factors that determine the incentives to work, save and invest, which ultimately determine the aggregate supply of the output of the economy. 

Differences in the approaches of Keynesian Demand Side theory and alternative supply side theory can we understood with the help of diagram. 

The diagram illustrates the emergence of Stagflation as the consequence of a shift aggregate supply curve due to the cost push factors. ( eg: rising oil prices ). As a result, it will be seen in the diagram, the price level rise to p1 and real GNP (output) would fall to y1, which will result in unemployment thus high inflation unemployment represents the state of stagflation.

Now, the supply sides economists argue that to get out of stagflation aggregate supply curve should be shifted to the right. As is evident in the diagram, with the right ward shift of the aggregate supply curve from AS1 to AS0, the economy moves from the equilibrium point E1 to E0 showing that while price level falls, aggregate national output increases, which will reduce the unemployment. Thus, in this way, through management of aggregate supply the economy can we lifted out of stagflation. 

In Order to tackle the problem of stagflation Keynesian policy of increasing aggregate demand, will only increase the price level as seen in the following diagram:- 

This illustrates the emergence of stagflation as a consequence of a shift in the aggregate supply due to the cost push factors and decline in productivity. Suppose aggregate supply curve shifts upwards to the left from AS0 to AS1 due to cost push factors, the price level increases to P1 and output would fall to P. This high inflation and high unemployment represents stagflation. Now the supply side economists argue that to get out of stagflation aggregate supply curve should be shifted to the right. The equilibrium point will move E1 to Eo indicating that the prices will fall from P1 to Po and real GNP or output increases from Y1 to Y0. Thus the economy can be lifted out of stagflation.