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 at low levels. Their general belief was that an increase in the demand for goods drives up prices, which in turn encourages firms to expand and hire additional employees, creating additional demand throughout the economy.
In the 1970s, however, a period of stagflation—or slow growth along with rapidly rising prices—raised questions about the assumed relationship between unemployment and inflation. In this article, we'll examine stagflation in the U.S. during that period, analyze the Federal Reserve's monetary policy (which exacerbated the problem), and discuss the reversal in monetary policy as prescribed by Milton Friedman that eventually brought the U.S. out of the stagflation cycle.
Those that 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 drive up demand and prices without stoking fears about inflation.
- Economists sometimes link employment to inflation.
- If the economy slows, the central bank can increase the money supply—causing prices to increase and unemployment to fall—without worrying about inflation, according to theories advanced by 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 gave credibility back to the Federal Reserve as his policies helped end the period of stagflation.
Beliefs about inflation and unemployment were based on the Keynesian school of economic thought, named after twentieth-century British economist John Maynard Keynes. According to this theory, the growth in the money supply can increase employment and promote economic growth.
In the 1970s, Keynesian economists had to reconsider their ideas, as industrialized countries around the globe entered into a period of stagflation. Stagflation is defined as slow economic growth occurring simultaneously with high rates of inflation.
When people think of the U.S. 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.
Indeed, inflation was high by U.S. historical standards: core consumer price index (CPI) inflation—that is, excluding food and fuel—reached an annual average of 13.5% in 1980. Unemployment was also high, and growth uneven; the economy was in recession from December 1969 to November 1970, and again from November 1973 to March 1975.
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. This was not inline with Keynesian economic theory.
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 help 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 to double-digit levels, reduced inflation, 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.
Deflation vs. Disinflation
Disinflation is a temporary slowdown in inflation, while deflation is the opposite of inflation and represents a decrease in prices throughout an economy.
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 15.84% in September 1981. This was 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 eventually gave credibility back to the Federal Reserve.
The Bottom Line
The job of a central banker is challenging, to say the least. Economic theory and practice have 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.