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17.2: Keynesian Economics in the 1960s and 1970s

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  • Learning Objectives

    1. Briefly summarize the monetarist school of thought that emerged in the 1960s, and discuss how the experiences of the 1960s and 1970s seemed to be broadly consistent with it.
    2. Briefly summarize the new classical school of thought that emerged in the 1970s, and discuss how the experiences of the 1970s seemed to be broadly consistent with it.
    3. Summarize the lessons that economists learned from the decade of the 1970s.

    The experience of the Great Depression led to the widespread acceptance of Keynesian ideas among economists, but its acceptance as a basis for economic policy was slower. The administrations of Presidents Roosevelt, Truman, and Eisenhower rejected the notion that fiscal policy could or should be used to manipulate real GDP. Truman vetoed a 1948 Republican-sponsored tax cut aimed at stimulating the economy after World War II (Congress, however, overrode the veto), and Eisenhower resisted stimulative measures to deal with the recessions of 1953, 1957, and 1960.

    It was the administration of President John F. Kennedy that first used fiscal policy with the intent of manipulating aggregate demand to move the economy toward its potential output. Kennedy’s willingness to embrace Keynes’s ideas changed the nation’s approach to fiscal policy for the next two decades.

    Expansionary Policy in the 1960s

    We can think of the macroeconomic history of the 1960s as encompassing two distinct phases. The first showed the power of Keynesian policies to correct economic difficulties. The second showed the power of these same policies to create them.

    Correcting a Recessionary Gap

    President Kennedy took office in 1961 with the economy in a recessionary gap. He had appointed a team of economic advisers who believed in Keynesian economics, and they advocated an activist approach to fiscal policy. The new president was quick to act on their advice.

    Expansionary policy served the administration’s foreign-policy purposes. Kennedy argued that the United States had fallen behind the Soviet Union, its avowed enemy, in military preparedness. He won approval from Congress for sharp increases in defense spending in 1961.

    The Kennedy administration also added accelerated depreciation to the tax code. Under the measure, firms could deduct depreciation expenses more quickly, reducing their taxable profits—and thus their taxes—early in the life of a capital asset. The measure encouraged investment. The administration also introduced an investment tax credit, which allowed corporations to reduce their income taxes by 10% of their investment in any one year. The combination of increased defense spending and tax measures to stimulate investment provided a quick boost to aggregate demand.

    The Fed followed the administration’s lead. It, too, shifted to an expansionary policy in 1961. The Fed purchased government bonds to increase the money supply and reduce interest rates.

    As shown in Panel (a) of Figure 17.4 “The Two Faces of Expansionary Policy in the 1960s”, the expansionary fiscal and monetary policies of the early 1960s had pushed real GDP to its potential by 1963. But the concept of potential output had not been developed in 1963; Kennedy administration economists had defined full employment to be an unemployment rate of 4%. The actual unemployment rate in 1963 was 5.7%; the perception of the time was that the economy needed further stimulus.

    Figure 17.4 The Two Faces of Expansionary Policy in the 1960s

    Expansionary fiscal and monetary policy early in the 1960s (Panel [a]) closed a recessionary gap, but continued expansionary policy created an inflationary gap by the end of the decade (Panel [b]). The short-run aggregate supply curve began shifting to the left, but expansionary policy continued to shift aggregate demand to the right and kept the economy in an inflationary gap.

    Expansionary Policy and an Inflationary Gap

    Kennedy proposed a tax cut in 1963, which Congress would approve the following year, after the president had been assassinated. In retrospect, we may regard the tax cut as representing a kind of a recognition lag— policy makers did not realize the economy had already reached what we now recognize was its potential output. Instead of closing a recessionary gap, the tax cut helped push the economy into an inflationary gap, as illustrated in Panel (b) of Figure 17.4 “The Two Faces of Expansionary Policy in the 1960s”.

    The expansionary policies, however, did not stop with the tax cut. Continued increases in federal spending for the newly expanded war in Vietnam and for President Lyndon Johnson’s agenda of domestic programs, together with continued high rates of money growth, sent the aggregate demand curve further to the right. While President Johnson’s Council of Economic Advisers recommended contractionary policy as early as 1965, macroeconomic policy remained generally expansionary through 1969. Wage increases began shifting the short-run aggregate supply curve to the left, but expansionary policy continued to increase aggregate demand and kept the economy in an inflationary gap for the last six years of the 1960s. Panel (b) of Figure 17.4 “The Two Faces of Expansionary Policy in the 1960s” shows expansionary policies pushing the economy beyond its potential output after 1963.

    The 1960s had demonstrated two important lessons about Keynesian macroeconomic policy. First, stimulative fiscal and monetary policy could be used to close a recessionary gap. Second, fiscal policies could have a long implementation lag. The tax cut recommended by President Kennedy’s economic advisers in 1961 was not enacted until 1964—after the recessionary gap it was designed to fight had been closed. The tax increase recommended by President Johnson’s economic advisers in 1965 was not passed until 1968—after the inflationary gap it was designed to close had widened.

    Macroeconomic policy after 1963 pushed the economy into an inflationary gap. The push into an inflationary gap did produce rising employment and a rising real GDP. But the inflation that came with it, together with other problems, would create real difficulties for the economy and for macroeconomic policy in the 1970s.