What is stagflation ?
The concurrence of a rising inflation rate and stagnant economic growth.
What are Stagflation causes in late 1960s and early 1970s ?
Consumer Price Index (% change from previous year) rose from 2% to above 6% from January’ 66 to January’ 70 indicating Inflationary pressures were starting to build after year 1965. Increased government expenditures for the Vietnam War and social programs with strong private demand pushed the economy beyond its capacity to produce. Wages began to accelerate resulting in compensation per hour grew by 6.6% per year. Real unit labor cost rose by 0.8% per year thus reducing overall corporate profit margins. This led to most severe recession since the Depression with inflation peaking at 18 percent in 1974 and unemployment peaking a year later at nearly 10 percent. 1970s was the beginning of the persistent and large US trade deficits. Taxes were up, buying power was down. As real wages fell, so too did confidence in the Fed. The Fed in 1970s is unable to produce a set of policies to help lift the economy out of the economic doldrums. The Fed tried to address the stagflation by raising fed funds rate from 6% to 9%. Recession occurred in 1973. The Fed, tried to utilize traditional expansionary fiscal policy to get the economy moving out of the 1973-75 recession with the Tax Reduction Act of 1975, but it was not enough to restore confidence.
Why was it so difficult a problem to deal with in 1970s (Why did policy makers fail to deal with it)?
The 1970’s stagflation (the concurrence of a rising inflation rate and stagnant economic growth) problem could not be treated with traditional aggregate demand (AD) oriented monetary and fiscal policies. An increase in aggregate demand – an outward shift in the AD curve – would move the intersection of the AS and AD lines up and to the right. Expansionary fiscal and / or monetary polices could offset the decline in output, but not without causing higher prices. Similarly, contraction polices designed to control inflation – an inward shift in the AD curve – would succeed at lowering prices, but only at the expense of even large declines in output and employment. The traditional policies in 1970s offered government policy makers (Fed) little guidance in dealing with the nation’s economic problems.
Using the aggregate demand/supply analysis, how did the Federal Reserve eventually solve the problem in 1980s?
In 1980s under the presidency of Ronald Regan the challenges were to reduce double-digit rates of inflation and to reduce the role of government involvement. Also by 1980 nearly one-third of all the gains in earnings made since 1948 had disappeared affecting the savings of all households. Most important of all is to regain the confidence of pubic on U.S. economic policies set by Fed. The Federal Reserve took a different approach to the problem by concentrating on the economy that has been hit by an adverse supply shock; the Fed in 1980s responded with appropriate policy that triggered a compensating supply shift and focused attention on aggregate supply.
First – monetary policy (restrict money supply) to control inflation. Second, government interferences with the economy is reduced – reducing government spending. Third, productivity growth needed is increased. As a result, inflation did drop drastically – from a high of 18 percent in early 1980 to 0 percent in March, 1982 – the first time that this had happened in a decade. The cost, at least initially, was higher unemployment, but eventually the unemployment rate began to fall and by 1989 it was 5.3 percent, the lowest rate since 1973 before the OPEC induced recession.
What lessons can the Fed learn from this experience?
The costs of even moderate high one-digit inflation were high. Only after the experiences of the 1970s were economic policy makers realized the flaws in trying to use stimulative macroeconomic policies to push the unemployment rate down below percent, and to hold it there.
Does this experience have any application to the current 2008 economic situation in the U.S.?
The 1970s was a decade of stagflation — the concurrence of a rising inflation rate and stagnant economic growth. The U.S. economy has not now reached the double-digit inflation rate (almost 15% by 1981), or the 9% unemployment rate, experienced back then. Inflation of 1970s is blamed because the Fed pumped money into the system too aggressively and Fed is not doing the same mistake in 2008.The Fed (Alan Greenspan’s Fed team) took too long to reverse the low fed fund rates of 2001-2003, thereby fueling the housing bubble whose collapse now threatens the economy. I believe a concentrated correction in housing sector will reduce damage spreading to other parts of economy.The Fed lowering the interest rates and Bush’s economic stimulus package will likely bring back the consumer confidence and growth in GDP, and biggest problem for Fed is to act cautiously during an election year, as it will face intense political pressure not to raise interest rates.