Stagflation in the 1970s

Until the 1970s, many economists believed that there was a stable inverse relationship between inflation and unemployment. They believe that inflation is tolerable because it means that the economy is growing and the unemployment rate will be at a low level. They generally believe that increased demand for goods will push up prices, which in turn will encourage companies to expand and hire more employees, thereby creating additional demand throughout the economy.

However, in the 1970s, a period of stagflation—or slow growth and rapidly rising prices—has raised questions about the hypothetical relationship between unemployment and inflation. In this article, we will examine the stagflation of the United States during this period, analyze the Fed’s monetary policy (which exacerbated the problem), and discuss the reversal of the monetary policy prescribed by Milton Friedman that finally freed the United States from stagflation. cycle.

Key points

  • Economists sometimes associate employment with inflation.
  • According to John Maynard Keynes (John Maynard Keynes) theory, if the economy slows down, the central bank can increase the money supply-leading to higher prices and lower unemployment-without worrying about inflation.
  • In the 1970s, Keynesian economists had to rethink their models because periods of slow economic growth were accompanied by higher inflation.
  • Milton Friedman’s policies helped end the period of stagflation and regained the Fed’s credibility.

Keynesian Economics

Those who believe that unemployment is inversely proportional to inflation believe that when the economy slows, the unemployment rate rises, but inflation falls. Therefore, in order to promote economic growth, a country’s central bank can increase the money supply to push up demand and prices without causing concerns about inflation.

The belief about inflation and unemployment is based on the Keynesian school of economic thought, named after the 20th-century British economist John Maynard Keynes (John Maynard Keynes). According to this theory, an increase in the money supply can increase employment and promote economic growth.

In the 1970s, as the global industrialized countries entered a period of stagflation, Keynesian economists had to reconsider their ideas. Stagflation is defined as the simultaneous occurrence of slow economic growth and high inflation.

1970s economy

When people think of the American economy in the 1970s, many things come to mind:

In November 1979, the price of a barrel of West Texas Intermediate crude oil exceeded $100 (calculated in 2019 U.S. dollars) and reached a peak of $125 in April of the following year (see figure below). This price level will not be exceeded in 28 years.

Crude oil price, 1965-1985 (unit: USD)

In fact, the inflation rate is high by US historical standards: the core consumer price index (CPI) inflation rate—that is, excluding food and fuel—reached an annual average of 13.5% in 1980. The unemployment rate is also very high, Uneven growth; economic recession from December 1969 to November 1970, and recession again from November 1973 to March 1975.

Stagflation, 1965-1985

The general view preached by the media is that high inflation is the result of oil supply shocks and the resulting increase in gasoline prices, thereby pushing up the prices of all other commodities. This is called cost-driven inflation. According to the prevailing Keynesian economic theory at the time, inflation should be negatively correlated with the unemployment rate and positively correlated with economic growth. Rising oil prices should have contributed to economic growth.

In fact, the 1970s was an era of rising prices and rising unemployment; periods of weak economic growth can be explained as cost-driven inflation caused by high oil prices. This is not in line with Keynesian economic theory.

Now a well-founded economic principle is that excess liquidity in the money supply will lead to price inflation; monetary policy in the 1970s was expansionary, which may help explain the rampant inflation at that time.

Inflation: a monetary phenomenon

Milton Friedman is an American economist who won the Nobel Prize in 1976 for his work on consumption, currency history and theory, and his demonstration of the complexity of stabilization policies. In a speech in 2003, Federal Reserve Chairman Ben Bernanke said:

Friedman’s monetary framework is so influential, at least in its broad outline, it is almost the same as modern monetary theory… His ideas have penetrated into modern macroeconomics, so much so that the biggest pitfall in reading him today is It is impossible to understand that his originality and his thoughts are even revolutionary compared with the mainstream views at the time.

Milton Friedman does not believe that costs drive inflation. He believes that “inflation is a monetary phenomenon whenever and wherever possible.” In other words, he believes that if the money supply is not increased, the price will not rise. In order to control the destructive effects of inflation on the economy in the 1970s, the Fed should adopt a tight monetary policy. This finally happened in 1979, when Fed Chairman Paul Volcker put the theory of monetarism into practice. This pushed interest rates to double digits, lowered inflation, and plunged the economy into recession.

The effective federal funds rate, 1965-1985

In a speech in 2003, Ben Bernanke said of the 1970s, “The Fed’s credibility as an inflation fighter has been lost, and inflation expectations have begun to rise.” The loss of the Fed’s credibility greatly increased the cost of achieving deflation. The severity of the worst economic recession after the war of 1981-82 clearly illustrates the danger of letting inflation run out of control.

This recession was so deep, precisely because the monetary policy of the previous 15 years did not anchor inflation expectations and wasted the Fed’s credibility. As inflation and inflation expectations remain high when the Fed tightens its policy, the impact of interest rate hikes is mainly reflected in output and employment, rather than rising prices.

Deflation and deflation

Deflation is a temporary slowdown of inflation, while deflation is the opposite of inflation and represents a decline in prices across the economy.

One sign of the Fed’s loss of credibility is the behavior of long-term nominal interest rates. For example, the 10-year U.S. Treasury bond yield peaked at 15.84% in September 1981. This is almost two years after Volcker’s Fed announced its deflation plan in October 1979, which shows that long-term inflation expectations are still in double digits. Milton Friedman finally allowed the Fed to regain its credibility.

Bottom line

To say the least, the job of a central bank governor is challenging. Thanks to economists such as Milton Friedman, economic theory and practice have improved a lot, but challenges continue to emerge. As the economy develops, monetary policy and its application methods must continue to adapt to maintain economic balance.


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