From Stability to Inflation 1950-1980

1. From Stability to Inflation 1950-1980

2. After World War II? • Post-World War II---all major economic powers except U.S. are devastated. U.S. has most of world’s gold supply and most of its productive capacity. • What kind of monetary system? • Classic Gold Standard----ensures long-term price stability and growth, but not short-term price stability. What’s the short-term. • Two Problems: (1) No one, except U.S. has large gold reserves (2) Adjustment during 1929-1939 seems too slow and costly

3. The Bretton Woods Monetary System • Abandon Classical Gold Standard • Conference at Bretton Woods (1944): modified gold standard. • U.S. has much of world’s monetary gold---so U.S.$ will be used as reserves in addition to gold.

4. The Bretton Woods Monetary System • Dollars are to be freely convertible at one ounce = $35 for international transactions but not for domestic—holding gold coins illegal. • U.S. is largest economy. Has large trade deficit-----buys goods and pays with dollars. Supports the revival of world’s economies. • U.S. Balance of payments deficits leads to accumulation of dollar claims by foreign treasuries-----a slowly growing problem.

5. And the Fed?The Treasury-Federal Reserve Accord, 1951 • The Federal Reserve regained its control over monetary policy • After Korean War, budget roughly in balance and no fiscal shocks. • The Fed targets nominal interest rates—raises them to counter inflation and lowers them to induce growth. William McChesney Martin---Chairman of the Fed 1951-1970

6. Price Stability & Growth in 1950s and early 1960s But what is this trend • U.S. Budget is largely balanced. • No external or internal shocks • 1950s and 1960s are “quiet” price stability and financial stability

7. Legacy of the Great Depression: Belief in Activist Fiscal Policy • Fear of unemployment. Keep it low. • The Phillips Curve? Economists find a trade-off between inflation and unemployment. • Paul Samuelson and Robert Solow (1960) identify 3% unemployment as goal but may have 6% inflation. Arthur Okun (1969) suggests 4% unemployment compatible with 2% inflation.

8. The Phillips Curve circa 1960

9. But the 1960s confound the curve What is going on????

10. But do we believe this now? • What happened when inflation increased? • Expectations alter the Phillips curve • How? Increased demand (More spending or lower interest rates)business hires more workersdrives up wages and prices & real costs, imagined profits vanish so reduce hiring • Increased employment is temporary at best.

11. Inflationary Pressures Build in the 1960s:Vietnam War and Great Society spending

12. International Consequences • Y = C + I + G + (X-M) • And…..M = M(Y) while X = X(Yforeign) • So if G is rising because of government spending on war and social security, medicare, and other programs and if C and I are rising because C = C(Y,i) and I =I(Y,i) • Large Trade Deficits, we pay in $US • By 1966, foreign central banks and governments held over 14 billion U.S. dollars. The United States had $13.2 billion in gold reserves.

13. Collapse of Bretton Woods and Restraint on Inflation • If all foreign central banks tried to convert their holdings at once, the United States would not be able to honor its obligations to convert $ into gold at $35 an ounce. • Instead: a slow run on the dollar. But U.S. does not respond by tightened monetary policy------continued loss. • Convertibility is suspended in August 1971 and officially in 1973---era of flexible exchange rates begins. • Demand and Supply determine $ value------no anchor left for the dollar!! Faster inflation

14. Increased Inflationary pressures • President Nixon attributed his defeat in 1960 to unwillingness of Eisenhower administration to stimulate economy even at risk of increasing inflation. • Eager for 1972 election to have good economy. Pressure on Arthur Burns—new Chairman of the Fed • Result is a monetary stimulus from the Fed----but inflation looms so price and wage controls are imposed Taught Milton Friedman at Rutgers

15. Increased Inflationary pressures • Wage and Price Controls? What are the effects? Shortages!!!! Quickly Abandoned and with a Surge in Inflation!! • Worse Yet? Oil price hikes 1973 & 1979---huge relative increase in commodity prices—the Fed is accommodative---keeps interest rates lowmore monetary expansion. • What do to?

16. 1979

17. October 6, 1979 • High unemployment and high inflation---over 10%, no Phillips-Curve trade off. • New chairman of the Federal Reserve—Paul Volcker. • On Saturday October 6, 1979, the Fed announces it will target monetary aggregates and federal funds rate allowed to fluctuate. • Bond prices collapse and interest rates jumpReal Interest Rates Jump. • Economy moves into deep recession 1981-1982 but drives inflation down to 4%. Fed slackens • Once inflation under control Fed changes to a policy of targeting the federal funds rate.

18. 1979 Result-----two severe recessions!!

19. Huge Cost to Drive Down Inflation: High Unemployment and First Financial Crisis Since the Great Depression

20. But no financial crisis for a long time after the New Deal. Why?1929 and 1950: Frozen by the New Deal?

21. Liquidity Effects of the Great Depression and World War II---and the unwinding

22. New Deal Restrictions • Limits on Price Competition: Regulation Q • Limits on Geographic Competition: Restrictions on Branching and Mergers • Limits on Product Competition: Narrowly Defined Banking---new products limited • Banks stay very profitable for a long time. • BUT……THE RISE IN INFLATION AND THE EFFORT TO REDUCE INFLATION EXPLODES THIS SYSTEM