ECO342H1 Lecture Notes - Lecture 10: Nominal Interest Rate, Taylor Rule, Money Supply
ECO342 – Lecture 10
10 The Inflation of the 1970s:
- It marks the end of Keynesian policies and the free market, anti-government policies of
monetarists
- There was widespread belief in the Phillips Curve and the fact that high inflation was a trade-
off for higher employment to reach and stay at full employment
- three bouts of inflation:
1. 1965 -1970: 2% to 6%/year
2. Mid-1972- 1974: 2% inflation to 12%
3. Late-1976 – 1979: 5% to 15%
- the last two coincided with recessions (“STAGFLATION”)
- cost-push argument is only valid for the second bout since that is the only time producer prices
led consumer prices
- inflation caused by many years of running the economy at more than full employment
- But Gordon et al argue that wages went up due to monetary supply expansion in the late 60s;
the demand for a rise in wages was in response to increasing prices
- the price of oil only increased from $3/barrel in 1967 to $3.56/barrel in 1973
- First big shock was in 1974 when the price of oil jumped from $4.31/barrel to $10/barrel as a
price increase from OPEC
- People assumed that this was retaliation for the loss of Arab nations against Israel in the Yom
Kippur War of 1973
- Hammes and Willis argued that the OPEC price shock was just a correction for the
depreciation in the USD, not a retaliation measure
- Gold and oil were brought back to the same parity of 12 barrels/oz during the 1960s in 1974;
the price of oil in gold crept up to 24 barrels/oz in 1973
- OPEC didn’t raise the price of oil, it simply accounted for the fall of the USD and since oil was
denominated in USD, everyone felt the shock
- the same happened in the late 70s when oil rose from $14 to $38/barrel (12 barrels/oz)
- Friedman argued that the oil shock didn’t cause inflation, it was caused by inflation in the
money supply; if the oil caused producer price shock, it would have reduced incomes and
deflation would have occurred
- The Fed kept on printing notes well into the 1970s and never stopped
- Nelson points out the “monetary policy neglect hypothesis;” Washington decided to maintain
full employment while implementing wage and price controls
- The cost-push argument was used by Arthur Burns to justify such spending
- Finally, in 1978, the US decided to exercise monetary restraint; a sharp increase in interest rates
followed
Taylor Rule:
- Taylor Rule: a nominal interest rate higher than inflation is required to slow down inflation
- the printing of US dollars was ultimately responsible for the inflationary era of 1965 to 1982;
the central bank should set nominal rate higher than inflation if it is above the target or if real
GDP is more than full employment GDP
- US Fed misunderstood the link between expansionary monetary policy and inflation
- this marked the start of the repudiation of government intervention in the economy
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Document Summary
It marks the end of keynesian policies and the free market, anti-government policies of monetarists. There was widespread belief in the phillips curve and the fact that high inflation was a trade- off for higher employment to reach and stay at full employment. 1965 -1970: 2% to 6%/year: mid-1972- 1974: 2% inflation to 12, late-1976 1979: 5% to 15% The last two coincided with recessions ( stagflation ) Cost-push argument is only valid for the second bout since that is the only time producer prices led consumer prices. Inflation caused by many years of running the economy at more than full employment. But gordon et al argue that wages went up due to monetary supply expansion in the late 60s; the demand for a rise in wages was in response to increasing prices. The price of oil only increased from /barrel in 1967 to . 56/barrel in 1973.
