During the late 1970s and the first part of the 1980s, the Fed seemed to react...

During the late 1970s and the first part of the 1980s, the Fed seemed to react in a counterintuitive manner to the 1970s oil shocks. Explain the reasoning behind the Fed's policy decisions and the effect that they had on the economy?

Expert Solution

As a result of the oil shocks from 1973 to 1979, the shock of supply was negative in the 1970s. This led to a state of stagflation in which both high inflation and high unemployment were registered. In reaction to these genuine shocks, the Fed was constrained in its capacity to increase growth; the Fed was especially concerned about inflation at the time and agreed to reduce money growth in order to prevent further growth in inflation.

The contractionary impact on aggregate demand contributed to a decrease in the rate of inflation but to an rise in the rate of unemployment. Such measures seem counterintuitive if the Fed is seen to be primarily concerned with unemployment. But with the same approach, the Fed can not fight both unemployment and inflation, and so must choose which problem to solve, with an expectation that solving one problem would mean aggravating the other in the short term.

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