Demand Side or Supply Side Stabilization Policies in a Small Euro Area Economy: A Case Study for Slovenia

The Great Recession, the financial and economic crisis of 2007 to 2009, was the most severe economic crisis since the Great Depression of the 1930s. As a consequence, stabilization policy, which was considered to be of less importance during the “Great Moderation” since the mid-1980s, again came to the fore in the industrialized countries. Monetary policy reacted quickly by expansionary measures, and fiscal policies followed by letting automatic stabilizers work and in some countries supporting them by discretionary measures such as tax reductions or increases in public expenditures. In the Euro Area, the leading role of monetary policy was even more pronounced than elsewhere as its member states had surrendered this instrument to the European System of Central Banks and the European Central Bank in particular. This implies that the only macroeconomic stabilization policy instrument available to Euro Area members was fiscal policy. It is therefore of interest to investigate again the role of fiscal policy in stabilizing an economy faced with a deep and (as it turned out in Europe) prolonged (double-dip) recession. It is of particular relevance whether fiscal policy instrument targeted at the expenditure side or at the revenue side are more powerful in stabilizing the economy. We apply SLOPOL10, a macroeconometric model of the Slovenian economy, and simulate it in various scenarios over the period 2018 to 2024. Our results show that those public spending measures that entail both demand and supply side effects are more effective in stimulating real GDP and increasing employment than purely demand side measures. Measures that increase research and development and those that improve the education level of the labour force are very effective in stimulating potential and actual GDP. Employment can also be effectively stimulated by cutting the income tax rate and the social security contribution rate, i.e. by reducing the tax wedge on labour income and positively affecting Slovenia’s international competitiveness. This shows that fiscal policy measures with a supply side component are much more effective than those that are purely demand side oriented.