Question on Supply Side Reforms and Appreciation

Readers Question: Assess the view that supply-side reforms have enabled the UK economy to be ‘more successful in maintaining growth, despite an appreciation in the value of its currency’ (Extract 1, lines 5-6}. (From Edexcel unit 3)

An appreciation in the exchange rate would tend to reduce aggregate demand and lead to lower economic growth. An appreciation makes exports less competitive, decreasing quantity of exports. An appreciation also  makes imports cheaper, increasing quantity of imports (and hence money leaving the economy). Therefore, the (X-M) component of AD will be lower. This will reduce Economic growth.

AD/AS Diagram showing effect of appreciation

However, an appreciation doesn’t necessarily lead to slower growth. If UK house prices have been rising, then there will have been a positive wealth effect leading to higher consumer spending. Also, if demand for exports is inelastic, an appreciation will not reduce the value of exports. Therefore, the strong growth in the UK may not be due to supply side policies but because AD continues to rise due to various other factors.

Supply side policies can help to increase growth. For example, recently, the government have attempted to improve education and training (new deal and other policies); this should increase labour productivity and shift AS to the right. Although, these take a long time they will help to increase the economic growth rate in an economy.

Diagram showing effect of Successful Supply Side Policies

supply-side-policies

Another supply side policy could be privatisation. This has helped increase the efficiency of privatised firms and boost productivity in the economy. This shift in AS helps to increase growth. It is also possible that successful supply side policies can increase confidence and investment in the economy and therefore, help boost AD as well as AS.

But, mainly supply side policies help to increase the long run trend rate of growth rather than deal with temporary demand side shocks. Supply side policies can help increase the long run trend rate, but, don’t necessarily increase AD.

Growth has been maintained in the UK because AD continues to rise as well as rising AS. This reflects the strength of consumer spending and perhaps expansionary fiscal policy.

To get full marks you would also need to make reference to the data and give precise figures.

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