IS-LMing the way to the “Great Inflation”

Ronald Reagan and Arthur Laffer would have been “proud” of John F. Kennedy:

“It is a paradoxical truth that tax rates are too high and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now … Cutting taxes now is not to incur a budget deficit, but to achieve the more prosperous, expanding economy which can bring a budget surplus.”

– John F. Kennedy, Nov. 20, 1962, president’s news conference

“Lower rates of taxation will stimulate economic activity and so raise the levels of personal and corporate income as to yield within a few years an increased – not a reduced – flow of revenues to the federal government.”

– John F. Kennedy, Jan. 17, 1963, annual budget message to the Congress, fiscal year 1964

“In today’s economy, fiscal prudence and responsibility call for tax reduction even if it temporarily enlarges the federal deficit – why reducing taxes is the best way open to us to increase revenues.”

– John F. Kennedy, Jan. 21, 1963, annual message to the Congress: “The Economic Report Of The President”

Meanwhile, at the CEA the “ingredients” for economic expansion were being diligently “mixed”. Arthur Okun (of Okun Law fame) invented the concept of “potential output”.  For him, the economy would be at its “potential” when unemployment was 4% (but later he said “we shouldn´t be content with that level of unemployment”). At the start of Kennedy´s administration unemployment was 7%.

At the same time, also at the CEA, James Tobin was setting forth the “principles” that should guide policy:

  1. The “new economics” (read “Keynesian economics) sought to liberate federal fiscal policy from restrictive guidelines unrelated to the performance of the economy.
  2. The Council sought to liberate monetary policy to focus it squarely on the same macroeconomic objectives that should guide fiscal policy.

That´s just another way of saying that the “policy mix” should contemplate expansionary fiscal (tax cuts) sanctioned by a monetary policy that kept the interest rate constant.

Finally, post mortem, Kennedy´s tax cut was sanctioned. The IS-LM chart shows the rationale for Tobin´s “principles”. The tax cut would have maximal effect if monetary policy helped keep the interest rate “constant” so as not to discourage investment.

 

The panel below shows the real world counterpart. Soon after the passage of the tax cut, NGDP climbed above trend. Initially, RGDP growth jumped because inflation remained constant. However, soon inflation began to drift up reflecting the rise in NGDP, consistent with the fact that the economy was growing above “potential” (note that after 1965 unemployment fell below 4%, Okun´s initial definition of “potential output”).  Real output growth plunged.

The next chart shows that interest rates had remained pretty much constant until 1965, but with the rise in inflation they quickly “took-off”.  Another example of the view that high (rising) rates reflect the fact that monetary policy had been “too easy”.

The aftermath was a decade of high and variable inflation, being dubbed “The Great Inflation”. In 1973 oil producers became the greatest “scapegoats” of the modern era, but only the consciously “blind” believe the tale that oil prices “caused” inflation. In fact, the reverse is true.

5 thoughts on “IS-LMing the way to the “Great Inflation”

  1. Isn’t the issue that the authorities were trying to push unemployment below what even they believed was consistent with potential output? Maybe you can weigh in on this one: I think Arthur Okun might have been right about being content about achieving such a level of unemployment, but without the implication that unemployment should be pushed down by easy monetary policy and deficit spending. My thought is that the rate of change in potential GDP may be seen as alterable, at least from a long-run perspective, if there were more investment in education, retraining and capital. Think of it this way: if you can take actions to raise the factor productivity of labor, then the unemployment rate consistent with potential output can be lowered over time. Anything wrong with this thought?

  2. Pingback: Some Clarity on the Krugman-Keen Debate | Last Men and OverMen

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