[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

John F. Kennedy’s economic advisers believed that a cut in the individual income
tax would cause households to consume more. This increased consumption would
lead to a rightward shift in the ADI curve. An increase in aggregate expenditures,
Kennedy’s advisers believed, would result in increased output and a lower unemployment
rate, not higher inflation. They argued that inflation would not rise, because
the economy had excess capacity—productive workers and machines were lying
idle. As a result, the shift in the ADI curve would be translated into increases in
output, as shown in Figure 31.7.
Increases in output, as we have learned, imply increases in employment. The
predictions of the economic advisers turned out to be correct. After taxes were cut
in 1964, unemployment fell to 4.4 percent in 1965 and stayed under 4 percent for
the rest of the 1960s. In addition, real GDP grew at the remarkable rate of 5.5 percent
from 1964 to 1966, while inflation initially remained at low levels. Figure 31.8
shows these developments. Output was below potential in 1962 and 1963, but the
output gap was shrinking and the unemployment rate was falling. The tax cut
boosted the economy and pushed output above potential by 1965.
According to our model, wages and prices start to rise more rapidly when the
economy is operating above potential. This is just what happened. Throughout the
late 1960s, inflation rose. Eventually, the economy fell back toward potential GDP,
just as the analysis illustrated in Figure 31.7 predicts. By the end of 1970, unemployment
was back above 5.5 percent. Inflation, which had averaged 1.3 percent in 1963,
averaged 5.7 percent in 1970.
8
6
Inflation
(left axis)
8
7
4
6
2
5
PERCENT
0
–2
–4
Output gap
(left axis)
Unemployment
(right axis)
4
3
2
PERCENT
–6
1
–8
0
1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971
Figure 31.8
THE OUTPUT GAP,
UNEMPLOYMENT RATE, AND
INFLATION RATE IN THE 1960s
The increase in aggregate demand during the 1960s lowered unemployment. As the
economy continued to expand above full-employment GDP, the rate of inflation increased.
By the end of the decade, the economy was back at full employment but with a higher
rate of inflation.
SOURCES: Economic Report of the President (2004) and Congressional Budget Office.
702 ∂ CHAPTER 31 AGGREGATE DEMAND AND INFLATION