Question

The period of 1960-1985 represents an unusual time in our country’s economic history where we experienced stagflation with high unemployment and high inflation at the same time. Describe and discuss the causes of the stagflation including Fiscal and monetary policy actions,various serious crises, and Economic Goals. Outline the Monetary Policy actions taken to alleviate the stagflation. Utilizing concepts discussed in the course, what steps could be taken to protect the economy from this environment in the future.

Please discuss and outline the arguments for and against the independence of the Federal Reserve Bank(Central Bank) from the Political Administration including the Congress. Which position is more persuasive to you and why?

Please discuss in 500 words or more.

Answer 1

Part 1)

The Concept of Stagflation was unknown to the United States prior to the period of 1960's to 1980's, where even though the unemployment levels were high in the economy, there still was inflation which rose steadily at 5 percent per year in 1970 and sky rocketed at 12% to 15% there on wards.

Stagflation is a strange thing to happen in economics as with increase in demand, unemployment usually declines but this was not the case in the economy back then. The core reasons for this was the rise in price of oil. The United States had to face steep prices in the international markets, as oil producing nations-imposed sanctions on the same. The resultant was that the overall cost of production increased and this was pushed on the prices. As inflation kept increasing, the producers got even lesser returns on the goods manufactured. Thus, they were unable to pay higher rates to the employees. The employees on their part were unable to sustain at the wage rates being provided as they were unable to make ends meet even when they were working hard. This led to a dual situation wherein employment levels were low while inflation remained high.

Monetary & Fiscal Policy Measures taken by the then government: -

The Monetary Policy is the prime responsibility of the Federal Bank, whereas the Fiscal Policy is regulated by the government. The Monetary Policy regulates the flow of money in the economy on one hand, and on the other, the fiscal policy aims to stabilize the economy through government expenditure or taxes.

In the scenario wherein the economy was facing stagflation i.e. high unemployment and high inflation rates, both these policies failed to help the economy revive. The government as well as the Federal Reserve stuck to the old plan of pumping money into the economy to reduce unemployment and expected that some inflation may exist.

This led to a harmful situation wherein the money in circulation increased, as the government reduced interest rates and taxes on one hand, while the Federal Reserve conducted various measures such as reducing the reserve requirements of commercial banks to increase the flow of money.

All this did was increase the flow of money in the economy, which led to hyperinflation and high prices on one hand, and on the other hand producers had very low levels of profits because of which the problem of unemployment still existed.

Future Corrections: -

In the eyes of most economists, the problem with stagflation is the over dependence on oil and other price rises which are beyond the control of the government. To reduce this, if the government can take active measures to reduce the dependency on oil it can help in reducing the problem of stagflation.

Also, another similar technique is to enhance the overall productivity in a nation by technological development which reduces the prices of goods and services so that they do not rise exponentially leading to such a critical economic situation in the future.

Part 2)

The Federal Reserve was established in the year 1913 with a view to stabilize the economy and ensure that bank runs which are events in which all customers of a bank rush to withdraw their money does not take place as it leads to large scale issues which are difficult to address for the government. Since then there has been independence which has been granted to the organization and is for the good.

Political decisions are often aimed at short term gains for a party and do not look into economics behind it. It can lead to long term consequences for any economy which will become extremely difficult to control. This is one of the key reasons why the Federal Reserve has been kept independent and should always remain like that.

For example, it may be in the political interest of the President to reduce the interest rates so that people can enjoy having higher income on their deposits and may give them political gains as the money in circulation increases. However, in reality this may not be required in the economy and may lead to inflation which is extremely harmful and has long term consequences.

As a result, most economists agree, that keeping the Federal Reserve free from political intervention is need of the hour.

Please feel free to ask your doubts in the comments section.