Overview of Supply Side Policy

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Literature Review
Overview of supply side policy
Word count (2927 words)

Literature Review
Overview of supply side policy
Word count (2927 words)

2Literature review3
2.1Keynesian and Neoclassical – what is supply side3
2.2Models for Supply Side4
2.2.1Cobb-Douglass Production4
2.2.2Aggregate Supply Model5
2.2.3Empirical models5
2.3Baseline model for policy implications – Laffer curve, Reaganomics8
2.3.2Empirical results9
2.3.4Policy implemented and critics10

This is the literature review on Supply Side Policy in modern economics. It gives an overview on different empirical model to test the fiscal policy and current debate on policy directed to alter the supply. In macroeconomics, there are always debates on what kinds of policies are best for growing and stabilizing economy. Policies, especially fiscal policies, are usually tied with political aim and objectives. It is a common knowledge that in 1930s, when there was Great Depression, Keynes proposed that there should be more of government interventions, suggesting that the market is not perfectly competitive and there is a market failure. Keynes’ proposal worked very well and it led policy makers to aggressively intervene markets and making the role of government bigger and bigger during the next decades. However, Keynesians, demand-siders, were bewildered with the fact that during 1970s US economy experienced stagflation, the economy with increasing inflation and increasing unemployment, which was believed to be impossible based on Philips curve. This state of the economy gave a rise for the supply-side policy makers, notable example as being the policy known as Reaganomics. Supply-siders argued that high tax rate at the time discourage labor population to work. Unfavorable environment of firms, reflected as high production cost, reduce supply to be produced. These are causing both high unemployment rate and high price level. High tax rate reduces incentive to work. Less incentive to work leads to reduction in labor supply making the unemployment rate higher. Phenomenal high oil price during 1980s made production cost to increase, hence, driving up price level and depressed supply. As Fisher (1985) says “Supply side policies, of which a reduction in the payroll tax is the standard example, promise to reduce both inflation and unemployment”. Supply-siders proposed tax rate reduction in order to stimulate supply while at the same time promising that tax revenue gain from output increase offsets the tax revenue loss caused by tax reduction. This offsetting mechanism is one of the implications of Laffer curve, main argument of supply side economists who were prospering during 1980s. Arguments and implications of supply side policies are discussed in depth below in literature review part.

Literature review
Keynesian and Neoclassical – what is supply side
According to Ture, (1983, p. 26) there is a two distinguished framework to analyze fiscal policies: the Keynesian and the Neoclassical (or supply side) approaches. Keynesian mainly focuses on Aggregate Demand (AD), using tax as a tool to affect income which directly affects consumption parameter of AD. On the other hand, income changes are second-order effects of taxes under the supply side approach. Changes in tax rates cause changes in the relative prices of income and leisure (the leisure-labor choice), and the relative prices of savings and consumption. These are called first-order effects. Magnitude of first order effect determines the second-order effect, the effect of tax rate change on income. Hailstones (1982, p. 3) defined Supply side economics as a study of policies formulated to stimulate economic growth and promote price stability through various measures, such as increased savings, greater investment, lower taxation,...
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