7 - The Start of the Great Inflation

Summary

Stop–go monetary policy began in Martin's final years as FOMC chairman. Why did he allow monetary policy to become inflationary?

The Spirit of Stop–Go Monetary Policy

In the 1960s, a demand for activist macroeconomic policy arose from a convergence of political imperative and intellectual consensus. An imperative for growth emerged out of the fiscal pressures created by the Vietnam War and the social divisions created by the war and the civil rights movement. President Johnson refused to choose between war expenditures and his Great Society programs. The economy had to grow flat-out to generate the revenues necessary to pay for guns and butter.

Riots in inner cities and the rhetoric of black militants polarized American society. The middle class watched in dismay as the pampered baby boom generation of students burned the American flag in street demonstrations. A political consensus arose on the need to maintain a rapidly growing economy and a low unemployment rate as a social balm for a deeply divided society. At the same time, a consensus existed within the economics profession that government should pursue an activist policy of aggregate demand management to assure steady growth and low unemployment. Keynesian economics promised to deliver the political imperatives of high growth and low unemployment.

With stop–go, policymakers pursued expansionary monetary policy when the unemployment rate was “high” under the assumption that aggregate-demand inflation could not arise with excess capacity in the economy.