Stagflation
As a final look at the long run impacts, we are going to review an extended example looking at stagflation. Recall that this situation is most likely caused by a negative supply shock, a significant shift of to the left. Not only does it cause a recession, lowering output and increasing unemployment but it also increases the price level.
If no policy action is taken, the transition to the long run is for prices to fall. The supply shock dissipates and GDP and unemployment return to where they were before.
If long run inflation expectations do not change, there is a similar outcome looking at Phillips curves. The short run Phillips curve shifts right, increasing inflation and increasing unemployment. The trade-off between inflation and unemployment also gets worse. For every level of unemployment, inflation is higher.
As the supply shock dissipates, the shifts back to its original position, returning unemployment and inflation to their starting levels.
As with any recession, policymakers may wish to shorten the recession rather than allow the economy to self-adjust. However, each policy option has significant trade-offs. To close a recessionary gap, our basic policy recommendation is expansionary policy.
Fiscal Policy Response
Expansionary fiscal policy could take the form of increased government spending, increased transfers, or tax cuts. Any of these would shift to the right, and regardless of the reason for a recession, these fiscal changes increase and .
This moves the economy along the new short run Phillips curve, with lower unemployment in exchange for higher inflation.
Real GDP and unemployment return to the long run level. In exchange the price level ends up permanently higher. Inflation itself comes back down once expectations settle, because the long run Phillips curve is vertical. In addition, the government takes on debt, which increases interest rates. This crowds out private investment and makes payments on previous debt more expensive.
Monetary Policy Response
Expansionary monetary policy is achieved by expanding the money supply, which lowers interest rates and shifts to the right. Policy lags are a factor that complicates monetary policy versus fiscal policy.
For monetary policy the important policy lag is implementation lag, which is slower. This means that monetary policy will overshoot, or push the economy past full employment in the short run. This is especially true if monetary policy is combined with fiscal policy. Given recent US experiences with responses to recessions and economic crises, it is also fair to assume overshooting because policymakers would prefer to do “too much” rather than “too little.”
The long run adjustment to this monetary policy action is for prices to adjust upwards and for inflation expectations to rise. Monetary policy does close the recessionary gap in the long run, but can be considered to cause additional inflation due to implementation lag.
Inflation expectations
The following discussion is slightly advanced for this level, but it highlights that the - model as we have seen it fails to pick up the full scope of the destructiveness of stagflation. The weakness is that permanent changes in inflation expectations shift as well.
Shocks that cause stagflation need not be transitory. If they are not, then expected inflation should rise. Because the changes are permanent, households prefer to purchase this year instead of next year and this increase in consumption shifts to the right.
This cycle can repeat for many steps before settling into a long run equilibrium. At each stage, expected inflation increases, shifting further left and to the right. The result will be an economy back at the original equilibrium level of GDP but with a much higher price level.
On the Phillips curve, unemployment returns to the natural rate, but inflation is significantly higher than the initial level. Recall that in the long run, the Phillips curve equilibrium level of inflation is the expected level of inflation.
Data example: Oil shocks of the 1970s and the Volcker recession
In the 1970s, the United States faced two large oil shocks stemming from political events in the Middle East. From October 1973 until March of 1974 the United States faced an oil embargo from oil producing Arab countries. Then in 1980, 4% of the world’s oil production was taken offline, and gas prices did not come back down until the mid-1980s.
For reference here is inflation from 1965-1985.
This gives a good idea why the base “year” for the CPI is the average of 1982-84.
The natural question is, if two oil shocks are what made inflation go up then what made inflation go down? The answer is primarily the actions of a new Chairman of the Federal Reserve, Paul Volcker, who was appointed in 1979 and would remain in the position until 1987.
Here is the Fed funds rate from 1965-1985.
Volcker raised the Fed Funds rate to over 19% and signalled a commitment to eliminating inflation. This caused a recession in 1980, with unemployment rising to over 10%. During the recovery unemployment did not significantly decline, which led to the second recession. This is sometimes called a “double-dip” recession, one where the recovery is incomplete. So output shrinks, then grows, but ends up shrinking again.
It was the addition of the commitment to eliminating inflation along with the actions that matched that goal are what “killed” inflation in the United States. When inflation expectations rise, strong action must be taken for them to drop again.
From 1984 up until COVID in 2020, inflation was broadly considered tamed. Although a more nuanced view would say that not only were better monetary policy choices made starting with Volcker, there was also a fair amount of luck.