Download Lecture 19: From Stability to Inflation: 1950-1980

From Stability to Inflation
1950-1980
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
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.
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.
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
Price Stability & Growth in 1950s and early 1960s
•
•
•
U.S. Budget is largely balanced.
No external or internal shocks
1950s and 1960s are “quiet” price stability and
financial stability
But what is
this trend
Inflation 1950-2005
(GDP Deflator)
10
9
8
7
Percent
6
5
4
3
2
1
0
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
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.
The
Phillips
Curve
circa
1960
But the 1960s confound the curve
What is going on????
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.
Inflationary Pressures Build in the 1960s:
Vietnam War and Great Society spending
Inflation 1950-2005
(GDP Deflator)
10
9
8
7
Percent
6
5
4
3
2
1
0
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
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.
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
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
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?
19
60
19
62
19
64
19
66
19
68
19
70
19
72
19
74
19
76
19
78
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
Interest Rates and Inflation
16
1979
14
12
10
8
6
4
2
0
10 Year US Bond Rate
Inflation Rate (CPI)
• High unemployment and high
inflation---over 10%, no PhillipsCurve 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.
October 6, 1979
Real and Nominal Rates of Interest
16
1979
14
12
10
6
4
2
0
19
60
19
62
19
64
19
66
19
68
19
70
19
72
19
74
19
76
19
78
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
Percent
8
-2
-4
-6
10 Year US Bond Rate
Real Rate of Interest
Result-----two severe recessions!!
Huge Cost to Drive Down Inflation: High Unemployment
and First Financial Crisis Since the Great Depression
Unemployment Rate
12.0
10.0
6.0
4.0
2.0
2008
2006.
2004.
2002.
2000.
1998.
1996.
1994.
1992.
1990.
1988.
1986.
1984.
1982.
1980.
1978.
1976.
1974.
1972.
1971.
1969.
1967.
0.0
1965.
Percent
8.0
But no financial crisis for a long time after the
New Deal. Why?
1929 and 1950: Frozen by the New Deal?
Liquidity Effects of the Great Depression and
World War II---and the unwinding
Number
of Banks
Total
Assets
$B
Share
in Loans
%
Share in
Bonds
%
Share in
Cash
%
Share in
Other
%
1929
24,970
62
58.1
21.0
14.5
6.5
1933
14,207
41
39.0
34.1
17.1
9.8
1940
14,534
68
25.0
35.3
35.3
4.4
1946
14,152
153
17.6
60.1
20.9
1.3
1960
13,503
243
47.7
30.9
19.3
2.1
1980
14,729
1,446
54.8
20.7
5.5
19.0
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