[MUSIC] Now let's turn to the topics of inflation and stagflation. Inflation has often been described as the cruelest tax because it eats away at our savings and at our paychecks. For example, if the rate of inflation exceeds the rate of growth in our paycheck, that means our real income or purchasing power is declining, even though our wages are going up. But not everyone loses from inflation. For example, as we learned in lecture one, inflation that is unanticipated can benefit borrowers at the expense of lenders. As a practical matter, there are two very different types of inflation economists have to worry about, demand-pull inflation and cost-push inflation. The essence of demand-pull inflation is, too much money chasing too few goods. And that's exactly what happened when the US tried to finance both guns and butter. Both the Vietnam War and the Great Society. Do you remember from lecture one how to use the aggregate supply, aggregate demand framework to depict demand-pull inflation? Take a few minutes to draw it. Does your figure look like this? Increased government expenditures on both guns and butter drive aggregate demand from AD to AD prime. And equilibrium output increases from E to E prime as real GDP expands. However, when real output rises far above potential output the price level moves up sharply as well. From P to P prime. In 1972, President Richard Nixon imposed price and wage controls and gained the nation a brief respite from the Johnson era inflation. However, once the controls were lifted in 1973, inflation jumped back up to double digits, helped in large part by a different kind of inflation then emerging, an inflation known as cost-push or supply side inflation. Cost-push or supply side inflation occurs when external shocks such as rapid increases in raw material prices or wage increases drive up production costs. In the early 1970s, such supply shocks included crop failures, a worldwide drought, and a quadrupling of the world price of crude oil. Again, do you remember from lecture one how to use the aggregate supply-aggregate demand framework to depict cost-push inflation? The cost-push situation in the 1970s is illustrated in this figure. Sharply higher oil, commodity, and labor costs increased the cost of doing business. The higher costs shift the AS curve up from AS to AS prime and the equilibrium shifts from E to E prime. Output declines from Q to Q prime, while prices rise. This leads to stagflation, the double whammy of both lower output and higher prices. Prior to the 1970s economists didn't believe you could even have both high inflation and high unemployment at the same time. If one went up, the other had to go down. But the 1970s proved economists wrong on this point, and likewise exposed Keynesian economics as being incapable of solving the new stagflation problem. The Keynesian Dilemma was simply this, using expansionary policies to reduce unemployment simply created more inflation while using contractionary policies to curb inflation only deepened the recession. That meant that the traditional Keynesian tools could solve only half of the stagflation problem at any one time. And only by making the other half worse. This dilemma was well illustrated by the ill fated initial Keynesian responses to the emerging stagflation crisis. During 1973 and 1974, inflation was labeled public enemy number one by policy makers even though there were clear signs of an accompanying recession. During both of these years, the Federal Reserve under Chairman Arthur Burns ordered sharp increases in the discount rate as a form of contractionary monetary policy. In addition, in 1974, President Gerald Ford responded to the crisis with a Whip Inflation Now campaign that included Keynesian calls for contractionary fiscal policy in the form of fiscal restraint and a tax surcharge. The result of these discretionary policies was to drive the economy deeper into recession even as oil price shocks in particular helped drive the inflation rate ever higher. Then, in 1975, alarmed by the deepening recession, the nation's policymakers switched their Keynesian strategy as they replaced inflation with recession as their number one policy worry. As Congress passed a $23 billion Keynesian tax cut to fight recession, the Federal Reserve switched to an expansionary Keynesian monetary policy. Result was a disaster. It drives home the seemingly unreconcilable dilemma that stagflation poses for traditional Keynesianism. High inflation remained, even as the economy failed to recover from recession. It was this inability of the Keynesian economics to cope with stagflation that set the stage first for professor Milton Friedman's monetarist challenge to what had become the Keynesian orthodoxy and then later for the emergence of supply-side economics. To better understand the failure of Keynesian activism in a world of stagflation, we have to delve more deeply now into modern inflation theory and the mysteries of the Phillips Curve.
