During inflation, the economy overheats, as the aggregate demand surpasses the level of economic growth. Thereby, the central bank plays a major role in employing the monetary policy, which encourages more saving than spending (Barsky and Lutz 18).
We will write a custom Term Paper on Inflation in the 1970s specifically for you
301 certified writers online
The most appropriate method is increasing interest rates, where, borrowing becomes very expensive, and people resolve to save instead of borrowing and spending money recklessly. Essentially, there is an increase in the opportunity cost of spending, and homeowners with mortgage find it too expensive to service their mortgage loans.
With a decrease in borrowings, the real money supply in the economy reduces significantly. Companies also find it very expensive to borrow monies from banks, thus, they end up making very few investments. Moreover, when the interest rate is significantly high, the exchange rate increases, and the inflation pressures reduce.
This reduces the demand for exports and makes imports slightly inexpensive. The situation becomes very difficult, as some businesses experience losses in some of their investment projects.
The entire scenario leads to an aggregate decrease in demand, where, buyers barely have enough money to spend, and the sellers have to reduce the prices of their products to obtain customers. Monetary policy is very effective in keeping inflation under control, as long as the interest rates are high.
The fiscal policy targets the demand side, and its effects to the economy resemble those of the monetary policy. During inflation, the government aims at reducing the flow of money in the economy by increasing direct taxes to the citizens.
This approach helps in reducing the amount of disposable income, as the citizens have to pay high taxes for every income that they earn or spend. High income taxes and high value added taxes play a significant role in reducing consumer spending.
Such a scenario aids and maintain steady budgeting, and thus, it supports economic growth in a given nation. The increased tariffs escalate the leakage rates, and the consumers are left with barely enough money to spend. Another approach of employing the fiscal policy is through the reduction of government spending in the economy.
In such a case, the reduced injections into the circular flow of the economy trim down the demand, which reduces inflation, and the general growth of the economy reduces significantly.
Exchange rate policy
Whenever the value of a currency appreciates, the exports become expensive, where, the volume of exports reduce significantly. Moreover, the aggregate demand for exports reduces significantly, and the firms in the country have to reduce their prices to remain competitive in the global market.
Whenever the currency in a particular nation is high, the import prices reduce significantly; therefore, firms that depend on imported raw materials experience reduced manufacturing costs. With that, the firms can sell their products at low prices, and still make profits.
Direct wage control is an important aspect of fiscal policy because it sets limits of wage bill and decrease expenditure in the government. A government experiencing inflation can restrict pay rise for government employees to cut on its expenditures.
Moreover, the government can go ahead and persuade private sector employers to control their wage levels. Despite the fact that low wage growth moderates inflation rate and reduces forces of inflation, it does not control inflation rate effectively.
Labour market and supply side policies
Reducing persistent uncompetitive markets and creation of flexible labour markets would play a great role in reducing inflationary pressures. The government can take part in weakening labour unions and encouraging part-time employment.
Get your first paper with 15% OFF
Although flexible labour markets lead to an increase in job insecurity, the increased flexibility in the labour markets would play a great role in helping firms to reduce their labour costs and thus reduce inflationary pressures. The lower cost per unit of production would enable firms to achieve economic growth without necessarily increasing their prices.
Economic policies that controlled inflation in the 1970s
The United States experienced a period of stagflation in the 1970s, where, the economic growth rate was slow and the inflation rates were considerably high. However, Milton Friedman, an American economist, believed that monetary supply was the issue affecting the economy.
He therefore insisted that the monetary policy would play a significant role in combating inflation of the 1970s. In 1979, Paul Volcker, the Federal Reserve Chairperson, employed the monetary policy, which played a great role in reducing inflation.
The increment of interest rates provides a way for the government to discourage spending and borrowing. In the middle part of 1970s, the interest rates increased to about 12%, as there was an excessive growth in the economy (Biven 28). Citizens resolved to save, and the real money supply in the economy reduced significantly. Although the monetary policy was the basis of the severe 1981-1982 recession period, it played a great role in combating the inflation of the 1970s.
Phillips curve and its application in the 1970s inflation
Phillips curve seeks to analyse the macro-economic situation and explain the correlation between inflation levels and the unemployment levels in any given economy. Since its implementation, the Philips curve has played a great role in managing the trade cycle, where, it helps policy makers to manage aggregate demand whenever the economy encounters high unemployment rates, inflation, and severe recession periods.
Essentially, the Philips curve indicated that wage inflation and unemployment levels have an inverse relationship. It is evident that changes in the levels of unemployment determine the price inflation levels in any economy. If, for example, there is an increase in the demand for labour, the unemployment levels fall, as firms raise their wages to compete for the few labourers available.
During the inflation period of the 1970s, the government had to select the most appropriate rate of inflation and work towards achieving it. Friedman studied the Phillips curve carefully, and discovered that the economy consisted of a series of short run Phillips curves that explained the natural rate of unemployment.
The short run Phillips curves played a great role in determining the existing inflation rate. Indeed, the entire period running through 1970-1979 had three short run Phillips curves that explained the upward shift of inflation expectations during the period.
While applying Milton Friedman’s monetary policy, the Phillips curve was imperative, and the economists had to contract or expand the economy accordingly to achieve the most appropriate rate of inflation (Marvin and King 993). The Phillips curve was imperative in incorporating the negative supply shocks experienced during the inflation period.
Therefore, although the stagflation period presented a breakdown of the Phillips curve in the 1970s, the curve had some relevance in achieving the monetary policy that combated the great inflation.
Barsky, Robert and Kilian Lutz. A Monetary Explanation of the Great Stagflation of the 1970s. Michigan: University of Michigan, 2010. Print.
Biven, Carl. Jimmy Carter’s Economy: Policy in an Age of Limits. North Carolina: University of North Carolina Press, 2002. Print.
Marvin, Goodfriend and Robert King. “The Incredible Volcker Disinflation.” Journal of Monetary Economics 52.1 (2005): 981-1015. Print.