Until the 1970s, many economists believed that there was a stable inverse relationship between inflation and unemployment. They believed that inflation was tolerable because it meant that the economy was growing and unemployment would be low. Their general belief was that an increase in demand for goods raises prices, which in turn encourages businesses to expand and hire additional employees, creating additional demand throughout the economy.
However, in the 1970s, a period of stagflation – or slow growth coupled with rapidly rising prices – raised questions about the assumed relationship between unemployment and inflation. In this article, we will examine stagflation in the US During that period, we will look at the monetary policy of the Federal Reserve (which exacerbated the problem) and discuss the reversal of monetary policy prescribed by Milton Friedman that eventually pulled the US out. Of stagflation. cycle.
- Economists sometimes link employment to inflation.
- If the economy slows down, the central bank can increase the money supply, causing prices to rise and unemployment to decline, without worrying about inflation, according to the theories of John Maynard Keynes.
- In the 1970s, Keynesian economists had to rethink their model because a period of slow economic growth was accompanied by higher inflation.
- Milton Friedman restored credibility to the Federal Reserve as its policies helped end the period of stagflation.
Those who argue that unemployment and inflation are inversely related believe that when the economy slows, unemployment rises, but inflation falls. Therefore, to promote economic growth, a country’s central bank could increase the money supply to boost demand and prices without stoking fears about inflation.
Beliefs about inflation and unemployment were based on the Keynesian school of economic thought, named after the 20th century British economist John Maynard Keynes. According to this theory, growth in the money supply can increase employment and promote economic growth.
In the 1970s, Keynesian economists had to rethink their ideas, as industrialized countries around the world entered a period of stagflation. Stagflation is defined as slow economic growth that occurs simultaneously with high rates of inflation.
Economy of the 1970s
When people think of the American economy in the 1970s, many things come to mind:
In November 1979, the price per barrel of West Texas Intermediate crude oil surpassed $ 100 (in 2019 dollars) and peaked at $ 125 the following April (see chart below). That price level would not be exceeded for 28 years.
Crude Oil Price, 1965-1985 (constant dollars)
In fact, inflation was high by historical US standards: core consumer price index (CPI) inflation – that is, excluding food and fuel – averaged 13.5% per year in 1980. Unemployment was also high, and uneven growth; the economy was in recession from December 1969 to November 1970, and again from November 1973 to March 1975.
The prevailing belief, promulgated by the media, has been that the high levels of inflation were the result of a shock in the supply of oil and the consequent increase in the price of gasoline, which pushed the prices of everything up. the rest. This is known as cost inflation. According to the Keynesian economic theories prevailing at the time, inflation should have had an inverse relationship with unemployment and a positive relationship with economic growth. Rising oil prices should have contributed to economic growth.
In reality, the 1970s were a time of rising prices and rising unemployment; All periods of low economic growth could be explained as a result of high oil price inflation, which pushes up costs. This was not in line with Keynesian economic theory.
A now well-founded economic principle is that excess liquidity in the money supply can lead to price inflation; Monetary policy was expansionary during the 1970s, which could help explain the runaway inflation at the time.
Inflation: monetary phenomenon
Milton Friedman was an American economist who won a Nobel Prize in 1976 for his work on consumption, monetary history, and theory, and for his demonstration of the complexity of stabilization policy. In a 2003 speech, Federal Reserve Chairman Ben Bernanke said:
“Friedman’s monetary framework has been so influential that, broadly at least, it has become almost identical to modern monetary theory … His thinking has so penetrated modern macroeconomics that the worst stumbling block to read today is not appreciating the originality and even revolutionary character of his ideas in relation to the dominant opinions at the time he formulated them. ”
Milton Friedman did not believe in cost-driven inflation. He believed that “inflation is always and everywhere a monetary phenomenon.” In other words, he believed that prices could not increase without an increase in the money supply. To control the economically devastating effects of inflation in the 1970s, the Federal Reserve should have followed a tight monetary policy. This finally happened in 1979 when Federal Reserve Chairman Paul Volcker put monetarist theory into practice. This drove interest rates to double-digit levels, lowered inflation, and sent the economy into a recession.
Effective Federal Funds Rate, 1965-1985
In a 2003 speech, Ben Bernanke said of the 1970s, “the credibility of the Fed as an inflation fighter was lost and inflation expectations began to rise.” The Fed’s loss of credibility significantly increased the cost of achieving disinflation. The severity of the 1981-1982 recession, the worst in the postwar period, clearly illustrates the danger of letting inflation spiral out of control.
This recession was so exceptionally deep precisely because of the monetary policies of the last 15 years, that they had unpinned inflation expectations and wasted the credibility of the Fed. Because inflation and inflation expectations remained stubbornly high when the Fed tightened, the impact of the increase in interest rates was felt mainly in production and employment rather than in prices, which continued to rise.
Deflation versus disinflation
Disinflation is a temporary slowdown in inflation, while deflation is the opposite of inflation and represents a decrease in prices throughout the economy.
An indication of the loss of credibility suffered by the Fed was the behavior of long-term nominal interest rates. For example, the yield on 10-year Treasuries peaked at 15.84% in September 1981. This was almost two years after the Volcker Fed announced its deflationary program in October 1979. suggesting that long-term inflation expectations were still in the double digits. Milton Friedman eventually restored credibility to the Federal Reserve.
The bottom line
The job of a central banker is challenging, to say the least. Economic theory and practice have vastly improved, thanks to economists like Milton Friedman, but challenges continually arise. As the economy evolves, monetary policy and the way it is applied must continue to adapt to keep the economy balanced.