Question

What factors contributed to the stagflation of the 1970s? How did Volker deal with the high inflation? Did high oil prices cause the stagflation or was it something else? Is the Fed independent? If so, how do our leaders ensure they maintain the best interests of the public? How does Milton Friedman establish his view that inflation is a monetary issue? According to Friedman, do trade unions cause inflation by pushing up wages and the cost of production?

Answer 1

Stagflation is when an economy experiences a slow economic growth along with high levels of unemployment and inflation. Stagflation often causes dilemma for the policy makers because when they focus on combating inflation, that might increase unemployment levels. Until the 1970's, economists were of the opinion that the relationship between inflation and unemployment is inverse but the stagflation during 1970s questioned this theoretical understanding about the nature of relationship between inflation and unemployment. Keynesian economists then had to reconsider their theories as the economies were experiencing periods of stagflation.

A significant factor that led to the episode of high inflation was supply shocks in oil. As the prices of gas increased, it led to an increase in the prices of various commodities. This can also be understood as cost push inflation. But Milton Friedman did not agree with this, he believed that inflation is always a monetary phenomenon, this means that he believed that inflation is always a result of increase in the money supply. Milton Friedman's theory of monetarism suggests that higher interest rates help in fighting inflation as it reduces the money supply in the economy. There is a reduction in the prices as the money in the hands of people is reduced.

Another factor was that the monetary authorities followed expansionary monetary policy which also led to inflationary pressure in the economy. In 1970s, it was seen that the Fed lost its credibility, this is people did not believe that the authorities could contain inflation effectively.

To get the situation under control, the Fed had to resort to a contractionary monetary policy. This was finally adapted in the year 1979 when Paul Volcker used the monetarist theory, that is, Volcker announced their disinflationary program. The result of this was that interest rates rose, inflation reduced and the economy slipped into recession.

The Federal Reserve is independent, this is because the central bank does not have to get the decisions they made regarding changes in monetary policy approved by the President. Their funding is approved by the Congress and a board of governors. However, in order to ensure that the interests of the public are not compromised, the Fed must submit a semi-annual report to Congress.