Limits of Monetary and Fiscal Policy

Support for activist economic policy was weakened considerably by the historical experience of the 1960s and 1970s. Output grew rapidly in the 1960s, but inflation, as measured by the rate of change in the consumer price index, rose from 0.7 percent during 1961 to 6.20 percent during 1969. In the 1970s, the economy experienced simultaneous increases in inflation and unemployment. This contradicted the idea of a stable trade-off between inflation and unemployment and led to a rethinking of the efficacy of fine-tuning. Given recent failures in fine-tuning the U.S. economy, some have taken the position that there is no predictable benefit to countercyclical policies. This argument is based on the belief that policy changes increase costly uncertainty among private-sector decision makers.

To be sure, changes in economic expectations place severe limits on the effectiveness of fiscal and monetary stabilization policy. People's actions depend not only on their current situation but also on their expectations for the future. For example, when the government introduces a temporary investment tax credit, businesses have an incentive to shift investment

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