Question

what role did the central banks（Federal Reserve System） play in the post 1979 period in increasing the level of unemployment? what effects did it have on wages, productivity, inflation and profits? what did Alan Budd and Alan Greenspan contribute to this idea?

( at least 150 words)

Answer 1

Twenty-five years ago, on October 6, 1979, the Federal Reserve adopted new policy procedures that led to skyrocketing interest rates and two back-to-back recessions but that also broke the back of inflation and ushered in the environment of low inflation and general economic stability the United States has enjoyed for nearly two decades. The dramatic policy actions by the Federal Reserve in 1979 represented an important break with the past, both in the way monetary policy was conducted and in the importance placed on controlling inflation.

From 1964 to 1984—Over the first fifteen years in the figure, inflation in the United States ratcheted upwards, averaging 2.6% per year from 1964 to 1968, 5% from 1969 to 1973, and 8% from 1974 to 1978. Then, in the first nine months of 1979, average annual inflation jumped to 10.75%. This dramatic rise was partially due to a new round of oil price increases. But even the core CPI, which excludes the volatile food and energy components, averaged a 9.4% annual rate.

Inflation at this high level during peacetime was unprecedented in American history. And it produced a variety of policies to tame it, including President Nixon’s wage and price controls, responsible for some of the temporary decline in inflation in 1971 and 1972, and President Ford’s WIN (for “Whip Inflation Now”) buttons, introduced in 1974.

While inflation was unusually high in 1979, unemployment was not. The United States had experienced a sharp recession in 1974 and 1975, with the unemployment rate reaching a peak of 9% in May 1975 and then declining steadily over the next four years. The unemployment rate averaged 5.8% during the first nine months of 1979. Thus, entering the fall of 1979, unemployment was slightly above its average over the previous fifteen years while inflation was at a troublingly high level.

During the late 1970s, the Fed implemented policy through procedures that were meant to control inflation by controlling the growth rate of the money supply. The basic approach was sensible—economy theory predicts that there is a close relationship between the average rate of inflation and the average rate of growth in the money supply. Beginning in 1975, the Fed was required by Congress to establish target growth rates for the money supply, to report the targets to Congress, and, if the targets were not met, to explain why not.

In practice, the Fed’s procedures sent conflicting and confusing signals to the public about the Fed’s desire to control inflation. Some of the confusion arose because the Fed established target ranges for several different measures of the money supply, or monetary aggregates as they were commonly called, without providing a clear statement about the relative importance of the different targets. The most important target ranges were those for M1 and M2, but target growth ranges were also adopted for M3 and bank credit. At times, one aggregate might be growing faster than consistent with its targeted range, while another aggregate was growing more slowly than its targeted range, making it difficult to predict whether the Fed would tighten to reduce the growth rate of the rapidly growing aggregate or loosen to accelerate the growth rate of the lagging one.

Another confusing aspect was the way policy decisions were expressed in terms of money growth targets and a desired range for the federal funds rate, the interest rate in the overnight market for reserves. In textbook treatments of policies to control the money supply, the central bank decides on the level of bank reserves consistent with the targeted money supply. The federal funds interest rate is then allowed to adjust freely to bring the demand for reserves in line with the supply of reserves set by the central bank. With the Federal Open Market Committee (FOMC), the Fed’s policymaking body, setting ranges for both money growth and the funds rate, it was not clear what would happen if, for example, the monetary aggregates grew faster than expected.

So it was a period of stagnation with high inflation and unemployment and also low productivity, wages and profit.

Friedman have long favored the use of strict rules to control the amount of money created. Alan Budd and Grrenspan said he is wrong and that discretion is preferable, indeed essential.

Inflation averaged 3.7% per year from the end of World War II to the Volker era, but only 2.4% per year during the Greenspan era. Even more important, inflation was much less variable. ... Greater price stability had far-reaching effects. By greatly reducing the uncertainties, enterprises could use their resources more efficiently and steadily. Price stability fostered innovation and supported a high level of productivity. ...

It has long been an open question whether central banks have the technical ability to maintain stable prices. Their repeated failures to do so suggested that they did not -- whence, in part, my preference for rigid rules. Alan Greenspan's great achievement is to have demonstrated that it is possible to maintain stable prices. He has set a standard. Other central banks around the world, whether independently or by following his example, are following suit. The timeworn excuses for central bank failure to stem inflation will no longer do. They will have to put up or shut up.