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In a nutshell

Supply-side economists support reductions in tax, because government revenue can increase (according to the Laffer curve) and businesses and consumers will be incentivised to invest (Mohr, Fourie, et al 2009:470). However, I do not see how is this supply-side. Tax and investment form part of the aggregate expenditure function, which determines aggregate demand (AD). So, surely a cut in tax will shift AD to the right?

More detail

I am currently trying to answer this question, related to cost-push inflation:

Provide two different methods for which a supply shock may revert back to the long-run equilibrium, without any external intervention. Give reasons to each answer provided.

When researching this question (vide Mohr, Fourie, et al 2009; Parkin, et al 2010; Arnold 2012), I could not find any mention of a self-regulating phenomenon in a free-market economy which results in the output being at potential GDP in the long-run. The textbooks that I consulted all assume that the government will step in to resolve the supply shock and to prevent stagflation from occurring. I am thus answering the question by outlining different strategies that the government can take. The one strategy (which is more interventionist than the others) is to decrease interest rates, which increases AD. Another strategy is an anti-inflammatory incomes policy. The third strategy is what Mohr, Fourie, et al. call "supply-side economics" (2009:470), which includes cuts in government spending, deregulation and reductions in tax.

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References

Arnold, R. 2012. Macroeconomics: Economics 144. 2nd custom edition. Hampshire: Cengage Learning.

Mohr, P, Fourie, L, et al. 2009. Economics for South African students. 4th ed. Pretoria: Van Schaik Publishers.

Parkin, M., Kohler, M., Lakay, L., Rhodes, B., Saayman, A., Schöer, V., Scholtz, F. & Thompson, K. 2010. Economics: Global and Southern African perspectives. Cape Town: Pearson Education.

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  • $\begingroup$ You should clarify with whoever assigned this to you whether government action is considered as "external intervention" or not -and if not then what does? International Institutions? $\endgroup$ – Alecos Papadopoulos Mar 29 '15 at 12:10
  • $\begingroup$ Two short comments: (i) For the Laffer curve claim, we actually need to be on the right side of it - yet to be proven. (ii) Whether aggregate expenditure goes up or down in equilibrium after a reduction in government expenditure depends on whether government expenditure crowds other spending (firm investments, consumption) in or out. $\endgroup$ – FooBar Mar 31 '15 at 15:08

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