ECON102: Principles of Macroeconomics (2021.A.01)

The path of U.S. inflation and unemployment followed a fairly consistent pattern of clockwise loops from 1961 to 2002, but the nature of these loops changed with changes in policy.

If we follow the cycle shown in Figure 16.4 "Connecting the Points: Inflation and Unemployment", we see that the three Phillips phases that began in 1961, 1972, and 1976 started at successively higher rates of inflation. Fiscal and monetary policy became expansionary at the beginnings of each of these phases, despite rising rates of inflation.

As inflation soared into the double-digit range in 1979, President Jimmy Carter appointed a new Fed chairman, Paul Volcker. The president gave the new chairman a clear mandate: bring inflation under control, regardless of the cost. The Fed responded with a sharply contractionary monetary policy and stuck with it even as the economy experienced its worse recession since the Great Depression.

Falling oil prices after 1982 contributed to an unusually long recovery phase: Inflation and unemployment both fell from 1982 to 1986. The inflation rate at which the economy started its next Phillips phase was the lowest since the Phillips phase of the 1960s.

The Fed's policies since then have clearly shown a reduced tolerance for inflation. The Fed shifted to a contractionary monetary policy in 1988, so that inflation during the 1986–1989 Phillips phase never exceeded 4%. When oil prices rose at the outset of the Persian Gulf War in 1990, the resultant swings in inflation and unemployment were much less pronounced than they had been in the 1970s.

The Fed continued its effort to restrain inflation in 1994 and 1995. It shifted to a contractionary policy early in 1994 when the economy was still in a recessionary gap left over from the 1990–1991 recession. The Fed's announced intention was to prevent any future increase in inflation. In effect, the Fed was taking explicit account of the lag in monetary policy. Had it continued an expansionary monetary policy, it might well have put the economy in another Phillips phase. Instead, the Fed has conducted a carefully orchestrated series of slight shifts in policy that succeeded in keeping the economy in the longest recovery phase since World War II.

To be sure, the stellar economic performance of the United States in the late 1990s was due in part to falling oil prices, which shifted the short-run aggregate supply curve to the right and helped push inflation and unemployment down. But it seems clear that a good deal of the credit can be claimed by the Fed, which paid closer attention to the lags inherent in macroeconomic policy. Ignoring those lags helped create the inflation-unemployment cycles that emerged with activist stabilization policies in the 1960s.