Brief History of Macroeconomic Thought and Policy

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.