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Supply-side economics is a theory that maintains that increasing the supply of goods and services is the engine of economic growth. Additionally, it advocates tax cuts as a way to encourage job creation, business expansion, and entrepreneurial activity.
Supply-side economics is sometimes known as Reaganomics for its association with President Ronald Reagan. He and his Republican contemporaries popularized the controversial idea that tax cuts for wealthy investors and businesses give them incentives to save and invest, producing economic benefits that trickle down into the overall economy.
Reagan often quoted the aphorism "a rising tide lifts all boats" to explain his take on the theory.
Like most economic theories, supply-side economics tries to explain both macroeconomic phenomena and—based on these explanations—offer policy prescriptions for stable economic growth.
In general, the supply-side theory has three pillars: tax policy, regulatory policy, and monetary policy. However, the single idea behind all three pillars is that production (i.e., the "supply" of goods and services) is more important than other variables in determining economic growth.
The supply-side theory is typically held in stark contrast to the Keynesian theory, which, among other facets, includes the idea that demand can falter. So, if lagging consumer demand drags the economy into recession, the government should intervene with fiscal and monetary stimuli.
This is the single big distinction: a pure Keynesian believes that consumers and their demand for goods and services are key economic drivers. In contrast, a supply-sider believes that producers and their willingness to create goods and services set the pace of economic growth.
Supply-side economics may be seen as the polar opposite of Keynesian, or demand-side, economics, which asserts that boosting demand for goods and services is the key driver of economic growth.
Economists review the supply and demand curves to support their arguments. The chart below illustrates a simplified macroeconomic equilibrium: aggregate demand and aggregate supply intersect to determine overall output and price levels. In this example, the output may be the gross domestic product (GDP), and the price level may be the Consumer Price Index (CPI).
The following chart illustrates the supply-side premise: an increase in supply (i.e., production of goods and services) will cause lower prices. Aggregate demand is assumed to have remained constant.
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When discussing supply, demand, prices, or economics in general, you'll often hear the phrase "ceterus paribus" or "all else remaining equal." It is used to explain that the theorist is isolating one variable's effects on another, assuming that all other variables that could affect the ones being explained remain constant.
Supply-side actually goes further and claims that demand is largely irrelevant. It says that overproduction and under-production are not sustainable phenomena.
Supply-siders argue that when companies temporarily "over-produce," excess inventory will be created, prices will subsequently fall, and consumers will increase their purchases to offset the excess supply. Demand must remain constant for this part of the theory to work.
This essentially amounts to the belief in a vertical (or almost vertical) supply curve, as shown in the chart below.
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The chart below illustrates the impact of increased demand: prices rise, but output doesn't change much. This chart assumes supply remains constant.
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Under such a dynamic—where the supply is vertical—the only thing that increases the output (and therefore economic growth) is increased production in the supply of goods and services as illustrated below (assuming demand remains constant):
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The three supply-side pillars emerge from these premises—Income tax policy, regulatory policy, and monetary policy.
Supply-siders argue for lower marginal tax rates, particularly marginal income tax. Supply-siders believe that lower rates will induce workers to prefer work over leisure (at the margin). Regarding lower capital-gains tax rates, supply-siders believe lower rates cause investors to deploy capital productively. A supply-sider would even argue that the government would not lose total tax revenue at certain rates because lower rates would be more than offset by a higher tax revenue base—due to greater employment and productivity.
Supply-siders tend to ally with traditional political conservatives—those who would prefer a smaller government and less intervention in the free market.
This is logical because supply-siders—although they may acknowledge that the government can temporarily help by making purchases—do not think this induced demand can either rescue a recession or have a sustainable impact on growth.
The third pillar, monetary policy, is especially controversial. Monetary policy is the Federal Reserve's ability to increase or decrease the quantity of dollars in circulation and adjust interest rates. Both are used in attempts to control growth and inflation.
A Keynesian tends to think that monetary policy is an essential tool for tweaking the economy and dealing with business cycles. In contrast, a supply-sider does not believe that monetary policy can create economic value.
While both sides agree that the government has a printing press, the Keynesians believe this printing press helps solve economic problems. But the supply-sider thinks that the government (or the Fed) is likely to create problems with its printing press by creating too much inflationary liquidity with expansionary monetary policy and not sufficiently "greasing the wheels" of commerce with enough liquidity due to a tight monetary policy.
A strict supply-sider is thus concerned that the Fed may inadvertently stifle growth.
Since supply-siders view monetary policy not as a tool that can create economic value but rather as a variable to be controlled, they advocate a stable monetary policy or a policy of gentle inflation tied to economic growth—for example, 3% to 4% growth in the money supply per year.
This principle is the key to understanding why supply-siders often advocate a return to the gold standard, which may seem strange at first glance (and most economists probably do view this aspect as dubious).
The idea is not that gold is particularly special but is the most obvious candidate as a stable "store of value." Supply-siders argue that if the U.S. were to peg the dollar to gold again, the currency would be more stable, and fewer disruptive outcomes would result from currency fluctuations.
As an investment theme, supply-side theorists say that the price of gold—since it is a relatively stable store of value—provides investors with a "leading indicator" or signal for the dollar's direction. Indeed, gold is typically viewed as an inflation hedge. And although the historical record is hardly perfect, gold has often given early signals about the dollar.
It is called supply-side economics because the theory believes that production (the "supply" of goods and services) is the most important macroeconomic component in achieving economic growth.
The opposite of supply-side economics is Keynesian economics, which believes that the demand for goods (spending) is the key driver for economic growth.
Reaganomics is a term for President Ronald Reagan's economic policies that focused on tax cuts for the wealthy, believing they would lead to savings and higher investments, producing economic benefits that would trickle down to the entire economy. Reaganomics also focused on increased military spending and the deregulation of domestic markets.
Keynesian economics is demand-side economics, which believes that demand in the economy is the key driver of growth. The increase or decrease in demand for goods and services impacts how much supply producers bring into the economy. Keynesian economists believe that if consumer demand is decreasing, then the government is responsible for increasing spending and intervening with fiscal and monetary stimuli.
Supply-side economics believes that producers and their willingness to create goods and services set the pace of economic growth. In contrast, demand-side economists believe consumers and their demand for goods and services are the key economic drivers.
Supply-side economics has a colorful history. Some economists view the supply-side as a useful theory. Other economists so utterly disagree with the theory that they dismiss it as offering nothing more than an updated view of classical economics.
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