Lesson 17-2Keynesian Economics in the 1960s and 1970s

Expansionary Policy in the 1960s Correcting a Recessionary Gap Kennedy proposed expansionary fiscal policy for the first time in U.S. history in 1961 and the Fed followed with expansionary monetary policy. By 1963, the U.S. economy was back at its potential output. Kennedy pressed for a tax cut in 1963 that was passed after his assassination,although the recessionary gap had already closed. Spending for the expanded Vietnam War added to the expansionary fiscal policy. The economy remained in an inflationary gap for the last 6 years of the 1960s.

The 1970s: Troubles from the Supply Side Macroeconomic Policy: Coping with the Supply Side The inflationary gap of the 1960s was closed by shutting off the expansionary fiscal and monetary policies that had sustained it.The economy went into recession with rising prices in 1970, so expansionary fiscal policy began creating an inflationary gap by 1974. The price of oil tripled, shifting the short-run aggregate supply curve to the left and resulting in a recessionary gap with rising prices. Two lessons had to be learned from the 1970s—the importance of monetary policy and the importance of aggregate supply.

The Monetarist Challenge The monetarist school holds that changes in the money supply are the primary cause of changes in nominal GDP. The leader of the monetarist school, even during the consensus over Keynesian economics, was Milton Friedman of the University of Chicago. Monetarists generally argue that the impact lags of monetary policy are so long and variable that trying to stabilize the economy using monetary policy can be destabilizing. 

Monetarists are critical of fiscal policy because of crowding out effects. Monetarists generally support a rule for the expansion of the money supply at a fixed annual rate. Friedman’s natural unemployment rate explained much of what was inexplicable by Keynesian theory. Events of the 1970s supported the significance of money supply growth to the economic course of the economy.

New Classical Economics: A Focus on Aggregate Supply New Classical economists focused on individual choices. They rejected the entire framework of macroeconomic analysis. They stressed the economy’s ability to achieve its natural level of output They used complex mathematical models to generalize from individual behavior to aggregate results. 

Changes in macroeconomic variables must come from changes in aggregate supply. This approach to macroeconomic analysis built from an analysis of individual maximizing choices is called new classical economics. The problems in the 1970s were said to be caused by stabilization policies that shifted aggregate demand to solve what were the results of rapid accomodation of shifts in long-run aggregate demand.

Rational Expectations A key theory of the new classical position is the rational expectations hypothesis which assumes that individuals form expectations about the future based on the information available to them, and that they act on those expectations. The founder of the rational expectations hypothesis is Robert E. Lucas of Carnegie-Mellon University. An implication of rational expectations is that monetary policy may not have any effect on real GDP unless it takes people by surprise. Fiscal policy doesn’t shift the aggregate demand curve at all but only changes the deficit or surplus.

Lessons from the 1970s The short-run aggregate supply curve cannot be viewed as something that provides a passive path over which aggregate demand can roam. The short-run aggregate supply curve can shift in ways that clearly affect real GDP, unemployment, and the price level. Money matters more than Keynesians had previously suspected. The work of monetarists showing a close correspondence between changes in M2 and subsequent changes in nominal GDP convinced many Keynesian economists that money is more important than they had thought. Stabilization is a more difficult task than many economists had anticipated. Shifts in aggregate supply can frustrate the efforts of policymakers to achieve certain macroeconomic goals.