Explain how fiscal policy can be used to try to improve the supply side of an economy. (June 2018)

Fiscal policy is the use of government spending and taxation to influence aggregate demand in the economy. Aggregate demand is the total planned spending in the economy and it consists of consumer spending, investment, government spending, and net exports - so AD = C + I + G + (X-M). If government spending was to be increased, the aggregate demand curve would shift to the right.

AD right shift diagram

The diagram shows that real gdp increases from y1 to y2 and price level increases from pl1 to pl2.

The government can use fiscal policy tools to influence the supply side of the economy as well. For example, they could specifically increase government spending on departments such as education. This would cause government spending and therefore AD to shift right - but it would also lead to workers becoming more skilled and capable of producing more. This increase in productivity means that the same number of workers will be able to produce a greater level of output without any extra strain. This means that there is an increase in the productive potential of the economy, which can be illustrated by a right shift in the long-run aggregate supply curve as shown below.

LRAS right shift diagram.

Another way that the government could use fiscal policy to improve the supply side of the economy is by reducing income taxes. This would cause more workers to be incentivised to work - particularly skilled workers who chose to retire early or leave the UK. They may return to the UK workforce and be willing and able to work. This means that firms would have a greater pool of workers to choose from and this would allow them to select an even more productive workforce, and this would also cause both AD and LRAS to shift to the right.