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Stagflation, 1970s Style

May 31 2009 | Filed Under Economics , Interest Rates

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 the economy was growing and unemployment would

be low. Their general belief was that an increase in the demand for goods would

drive up prices, which in turn would encourage firms to expand and hire

additional employees. This would then create additional demand throughout the

economy.

According to this theory, if the economy slowed, unemployment would rise, but

inflation would fall. Therefore, to promote economic growth, a country's

central bank could increase the money supply to drive up demand and prices

without being terribly concerned about inflation. According to this theory, the

growth in money supply would increase employment and promote economic growth.

These beliefs were based on the Keynesian school of economic thought, named

after twentieth-century British economist John Maynard Keynes. (For related

reading, see Understanding Supply-Side Economics.)

In the 1970s, Keynesian economists had to reconsider their beliefs as the U.S.

and other industrialized countries entered a period of stagflation. Stagflation

is defined as slow economic growth occurring simultaneously with high rates of

inflation. In this article, we'll examine 1970s stagflation in the U.S.,

analyze the Federal Reserve's monetary policy (which exacerbated the problem)

and discuss the reversal in monetary policy as prescribed by Milton Friedman,

which eventually brought the U.S. out of the stagflation cycle. (For more on

Friedman's economics, see Monetarism: Printing Money To Curb Inflation.)

1970s Economy

When people think of the U.S. economy in the 1970s the following comes to mind:

High oil prices

Inflation

Unemployment

Recession

Indeed, the average price of a barrel of oil reached a peak of $104.06 (as

measured in 2007 dollars) in December of 1979. (Want to read more about how

inflation affects the value of your dollar in the future? Read our tutorial,

All About Inflation.)

Figure 1 shows a history of oil prices as measured in 2007 dollars.

Figure 1

Source: InflationData.com as of 1/16/2008

Inflation was also high by U.S. historical standards. Figure 2 shows

year-over-year percentage changes in the core Consumer Price Index (CPI) (the

CPI less food and energy expenditures).

Figure 2

Source: Bureau of Labor Statistics

In the 1970s, there was a two-year period of economic contraction as measured

by gross domestic product (GDP) in year 2000 dollars (i.e. Real GDP): 1974 GDP

contracted 0.5%, and in 1975, GDP contracted 0.2% and unemployment reached

8.5%. In 1980, GDP contracted 0.2%. (To learn more, read The Importance Of

Inflation And GDP.)

The prevailing belief as promulgated by the media has been that high levels of

inflation were the result of an oil supply shock and the resulting increase in

the price of gasoline, which drove the prices of everything else higher. This

is known as cost push inflation. According to the Keynesian economic theories

prevalent 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 was an

era of rising prices and rising unemployment; the periods of poor economic

growth could all be explained as the result of the cost push inflation of high

oil prices, but it was unexplainable according to Keynesian economic theory.

(For more, see Cost-Push Inflation Versus Demand-Pull Inflation.)

A now well-founded principle of economics is that excess liquidity in the money

supply can lead to price inflation; monetary policy was expansive during the

1970s, which could explain the rampant 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, the chairman of the

Federal Reserve, Ben Bernanke, said, "Friedman's monetary framework has been so

influential that in its broad outlines at least, it has nearly become identical

with modern monetary theory His thinking has so permeated modern

macroeconomics that the worst pitfall in reading him today is to fail to

appreciate the originality and even revolutionary character of his ideas in

relation to the dominant views at the time that he formulated them."

Milton Friedman did not believe in cost push inflation. He believed that

"inflation is always and everywhere a monetary phenomenon." In other words, he

believed prices could not increase without an increase in the money supply. To

get the economically devastating effects of inflation under control in the

1970s, the Federal Reserve should have followed a constrictive monetary policy.

This finally happened in 1979 when Federal Reserve Chairman Paul Volcker put

the monetarist theory into practice. This drove interest rates down to

double-digit levels, reduced inflation down and sent the economy into a

recession.

In a 2003 speech, Ben Bernanke said about the 1970s, " the Fed's credibility

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 1981-82 recession, the worst of the postwar

period, clearly illustrates the danger of letting inflation get out of control.

This recession was so exceptionally deep precisely because of the monetary

policies of the preceding 15 years, which had unanchored inflation expectations

and squandered the Fed's credibility. Because inflation and inflation

expectations remained stubbornly high when the Fed tightened, the impact of

rising interest rates was felt primarily on output and employment rather than

on prices, which continued to rise. One 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 15.3% in September 1981 -

almost two years after Volcker's Fed announced its disinflationary program in

October 1979, suggesting that long-term inflation expectations were still in

the double digits. Milton Friedman gave credibility back to the Federal

Reserve. (For further reading, see The Federal Reserve.)

Conclusion

The job of a central banker is challenging to say the least. Economic theory

and practice has improved greatly thanks to economists like Milton Friedman,

but challenges continuously arise. As the economy evolves, monetary policy, and

how it is applied, must continue to adapt to keep the economy in balance.

For additional information, read Macroeconomic Analysis.

by Barry Nielsen