Case Studies
Supply Shock Inflation
 Typically the major cause of inflation is an excessively rapid growth of aggregate demand…of the demand for goods and services…a growth rate that outstrips the rate at which the economy’s productive capacity is increasing. However in the 70’s America faced with this new kind of inflation, one based on supply and not demand. This type of inflation, often called "cost-push" or supply shock inflation, is caused not by demand growing very rapidly, but by supply growing very slowly…or even in some cases contracting
Supply shock inflation in the 70’s was caused by worldwide crop failures followed by the Arab Oil Embargo. This caused US reserves of grain and oil to plummet. Prices on virtually everything shot upward. Inflation hit 10.8% and the nation reeled from its two supply-shocks.
These kind of supply shocks first caused food and energy prices to soar. Beyond that, these agricultural and energy products…and especially the energy products…are inputs to other productive processes, so other manufacturers have to use these things to produce other goods, and therefore, because they were suffering cost increases, the prices of these other manufactured goods went up.
This economic combination created something new: supply shock inflation and recession. People called it stagflation.
A Focus on Inflation
 For most of 1973, employment remained relatively high, and it was natural forgovernment leaders and economists to think that the problem of inflation was due to excessive demand. The Fed or policy-makers in general…or economists for that matter…didn’t understand well how the oil price shock affected the economy.
So the Federal Reserve, under the leadership of Chairman Arthur Burns, sought to fight inflation by restricting the money supply. In late 1973, the Fed raised the interest rates charged to member banks to cool the economy by moderating the expansion of credit and disciplining inflationary psychology.
And the Feds’ actions didn’t halt the inflationary spiral, even with another raise in the interest rates.
An economic summit conference was convened by the administration. The majority of economists present spoke out about the deepening recession and wanted to stimulate the sagging economy. Despite the signs of worsening stagflation, despite the message from the economic summit, neither President Ford nor Burns, could bring themselves to alter the policy of fighting inflation. Their policies relied on the old formulas, a tight ceiling on federal spending, and a tax surcharge. Finally, soaring unemployment figures convinced the administration that a policy change was due. President Ford bowed to the inevitable. Ford began to shift our emphasis from inflation to recession and offered a tax relief package.
| Comment & Analysis by Richard Gill Well, the reason the government was running into difficulty fighting problems with the economy at this time was that they were trying to deal with the problem too exclusively from the demand side. |
Is Inflation Dead?
 Over the years the Federal Reserve came to assume that the economy could not experience prolonged growth above two and a half percent a year without causing inflation. And yet in the 1990’s, growth was double that. Unemployment was at a thirty-year low, and all without waking the sleeping giant of inflation.
A major factor in keeping inflation at bay was the revolution in information technology. The digitization of all information created new companies and new industries. The technology revolution contributed to an increase in productivity, creating a new economy. Another factor was the globalization of business in preventing inflation. The introduction of market forces, freer trade, and widespread deregulation, meant that international trade and investment played a much larger role in our economy than before.
There was a lot of emphasis on expenditure restraint, and that was particularly strong during the 1990’s. Still economists believe inflation has been a recurrent characteristic of modern capitalism and we need to be wary not to be complacent during long periods of stability.
| Comment & Analysis by Nariman Behravesh Behravesh asserts that any claim that inflation is dead must be backed up by the assumption that productivity growth will remain strong. Unfortunately as the experience the 1970’s showed us, there is no guarantee that productivity growth will continue to be robust. Thus the Fed has to remain vigilant against the possibility that inflation will be resurrected once again. |
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