The fall of the Keynesian Consensus may be dated from Milton Friedman’s Presidential Address to the 1967 meeting of the American Economic Association. The main target of Friedman’s critique was an adaptation of the Phillips Curve, which began as an empirical observation but had by then been transformed into an analytical function—a precise and stable tradeoff between inflation and unemployment that served to close the familiar four-quadrant relationship among money markets, investment and output, and output and employment. It completed the Keynesian model, creating a satisfying closed system within which the impact of the levers of monetary and fiscal policy on output, employment, and inflation might be analyzed.
Friedman argued that the trade-off could only be a short-run phenomenon. In the longer run, once actors in the economy had fully absorbed and could anticipate the rate of inflation, the Phillips Curve would be vertical at a given level of employment—the natural rate. Hence, monetary policy might affect the employment-inflation trade-off in the short run, but in the long run it could not influence the level of employment that is “ground out by the Walrasian system of general equilibrium equations” (Friedman, 1968, p. 8). Similarly, fiscal policy could have no permanent effect on output. An increase in government spending would result in a higher rate of interest, “crowding out” private-sector investment.
The events of the 1970s, in particular the coexistence of high rates of inflation and rising unemployment following the oil crisis of 1974,