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April 13, 2021 

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LAFFER CURVE: The graphical inverted-U relation between tax rates and total tax collections by government. Developed by economist Arthur Laffer, the Laffer curve formed a key theoretical foundation for supply-side economics of President Reagan during the 1980s. It is based on the notion that government collects zero revenue if the tax rate is 0% and if the tax rate is 100%. At a 100% tax rate no one has the incentive to work, produce, and earn income, so there is no income to tax. As such, the optimum tax rate, in which government revenue is maximized, lies somewhere between 0% and 100%. This generates a curve shaped like and inverted U, rising from zero to a peak, then falling back to zero. If the economy is operating to the right of the peak, then government revenue can be increased by decreasing the tax rate. This was used to justify supply-side economic policies during the Reagan Administration, especially the Economic Recovery Tax Act of 1981 (Kemp-Roth Act).

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SUPPLY-DRIVEN BUSINESS CYCLES:

Business-cycle instability caused by changes in one or more of the determinants underlying the aggregate supply of gross domestic product--including resource quantity, resource quality, and resource price. This is one of two basic types of business cycles--the other being demand-driven business cycles. Supply-driven business cycles tend to be the less common of the two types.
Supply-driven business cycles occur when shocks to the aggregate supply side of the economy create instability. An increase in aggregate supply triggers an expansion and a decrease in aggregate supply causes a contraction.

While the factors that influence the supply of gross domestic product--including production cost, technology, and resource quantity--tend to change slowly and are more relevant for long-run economic growth, they have triggered short-run business-cycle instability. The most noted example was stagflation during the 1970s that occurred due to higher energy prices and other disruptions on the supply side.

The Process

Regardless of which aggregate supply determinant does the changing, the overall pattern is much the same.
  • Heading Down: A supply-driven business-cycle contraction results from a decrease in aggregate supply caused by higher production cost (especially wages or energy prices), a decline in technology (rare, but possible), or a decrease in the quantity of any resource (labor, capital, land, or entrepreneurship).

    The resulting decline in production capabilities means less gross domestic product is available for purchase by the four aggregate sectors. Consumption expenditures, investment expenditures, government purchases, and net exports necessarily decline. If the decrease in aggregate supply is the result of anything other than a decrease in the quantity of labor, then the decline in production entails an increase in unemployment. Because the four aggregate sectors are unable to buy all of the gross domestic product that they previous wanted, then they are likely to offer higher prices, meaning inflation tends to rise.

    The end result is a business-cycle contraction. Less output is produced and unemployment is higher. This contraction, however, has a twist. Inflation is also higher.


  • Going Up: A supply-driven business-cycle expansion results from an increase in aggregate supply, caused by lower production cost, a jump in technology, or an increase in the quantity of any resource. The resulting expansion in production capabilities means more gross domestic product is available for purchase by the four aggregate sectors. The end result is a business-cycle expansion. More output is produced and unemployment is lower. This expansion also has an added benefit. Inflation is lower.

Unemployment And Inflation

An important implication of supply-driven business cycles is the lack of a tradeoff between unemployment and inflation.
  • During the contraction phase of a supply-driven business cycle, both unemployment and inflation tend to increase.

  • During the expansion phase of a supply-driven business cycle, both unemployment and inflation tend to decrease.
Unemployment and inflation generally change in the same direction (both increasing or both decreasing) during supply-driven business cycles. As such, policies that seek to work with a tradeoff between unemployment and inflation generally worsen both at the same time.

Long-Run Growth

Supply-driven business cycles are not the norm when it comes to instability. Most business-cycle instability is demand driven. The reason is that supply-side factors tend to change slowly and predictably. Much like the sun rises each morning, the quantities of labor and capital increase steadily each year. Technology, education, and other resource quality attributes also increase slowly and relatively predictably. These things DO change, but they change so predictably that they are part of the basic structure of the economy. Government and business leaders generally plan on a given level of change in these factors when implementing policies.

Supply-driven business cycles result when these things DO NOT change as expected; when technology does not increase as expected or when it has a monumental surge; when an usually high or low number of people enter or leave the labor force; or most notably, when a production-cost component, such as energy prices, takes a big jump or drop.

<= SUPPLY DETERMINANTSSUPPLY INCREASE =>


Recommended Citation:

SUPPLY-DRIVEN BUSINESS CYCLES, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2021. [Accessed: April 13, 2021].


Check Out These Related Terms...

     | demand-driven business cycles | investment business cycles | political business cycles |


Or For A Little Background...

     | business cycles | expansion | contraction | business cycle phases | potential real gross domestic product | peak | trough | long-run trend | full employment | economic growth |


And For Further Study...

     | business cycle indicators | leading economic indicators | coincident economic indicators | lagging economic indicators | stabilization policies | unemployment | inflation | real gross domestic product | aggregate supply determinants | wages, aggregate supply determinant | technology, aggregate supply determinant | energy prices, aggregate supply determinant |


Related Websites (Will Open in New Window)...

     | National Bureau of Economic Research |


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