This chapter explores recent changes in economic conditions and studies alternative policies that respond to the age-old problems of unemployment and inflation.
The Phillips curve shows a historical trade-off between a high rate of inflation and a high rate of unemployment. In the 1960s, U.S. policymakers used this trade-off to promote an acceptable combination of inflation and unemployment.
|Policy makers during the Lyndon Johnson administration believed they could fine tune the economy. From 1964 to 1968, the government used policies to reduce the unemployment rate from five to 3.8 percent, which only increased inflation by three percent.|
Phillips Curve Shift
The U.S. economy in the 1970s did not conform to the trade-off shown in previous Phillips curve statistics, which suggested the Phillips curve had shifted.
The 1970s experienced simultaneous excessively high rates of unemployment and inflation. Economists offered various explanations for this combined phenomenon, including a rise in commodity price rises, the oil crisis, inflation expectations, changes in labor force composition, and an over-reliance on recurring Keynesian aggregate demand policies.
|In 1975, high unemployment (8.3 percent) and inflation (nine percent) rates presented an economy plagued by two concurrent undesirable conditions.|
The period of stagflation lasted longer, and inflation was more entrenched than expected, due to inflation expectations. For example, since Americans expected inflation to continue rising, they took measures to overcome its effects, such as inserting cost of living adjustment clauses into employment contracts and indexing interest rates.
|Before the 1970s, indexed interest rates or wages did not exist in the United States. Today, variable mortgage rates are common (even in 2002 when inflation was practically non-existent) and incorporated into most mortgages. For variable mortgage rates, the interest rate is recalculated at different agreed-upon times, so the mortgage rate is several percentage points above a chosen average, such as the annual treasury bill yield. Essentially, banks build the inflation rate into the mortgage interest rates they charge to protect themselves from losses due to inflation.|
One explanation for stagflation is that expansionary fiscal policies can only reduce unemployment for a short period. Re-employed workers discover the increase in inflation has eroded their income's purchasing power and decide it no longer makes financial sense to go to work. Successive expansionary policies increase inflation further, as businesses pass along increases in the interest rates to consumers, which further increases prices and costs.
|During the 1970s, the economy seemed to return to an ever higher rate of natural unemployment after each recessionary period. New entrants to the labor force and people changing jobs created more natural unemployment. Economists attributed the higher rate of natural unemployment to demographic changes, such as growing participation rates of women in the labor force.|
The rational expectation theory suggests individuals and firms will not take corrective actions during periods of difficulty, but wait for the government to stimulate the economy with appropriate policies.
|During the 1970's, successive U.S. administrations used expansionary fiscal policies on a recurring basis. People expected government to continue these policies.|
Labor Cost and Productivity
Another explanation of stagflation in the 1970s is tied to the declining productivity gain. If wage rates increase (dW) at the same rate as productivity gains (dProd), then labor cost increase (dLC) will be zero: dLC = dW − dProd = zero. However, a decline in productivity gains (which occurred in the 1970s) will produce higher labor costs and cost-push inflation. Increase in productivity gains (which occurred in the 1990s) permitted increases in incomes without inflation.
|Since 1900, the rate of productivity gain has been about 2.7 percent per year. It compensated wage increases and resulted in virtually no cost-push inflation. In the 1970s, productivity gain rate fell by more than half. Consequently, businesses had to pass along any wage increases onto consumers to remain in business.|
Policy makers have traditionally dealt with inflation by improving the ways the market functions. For example, we can avoid labor market bottlenecks by increasing the flow of information, providing retraining, facilitating worker mobility, and reducing discrimination. Another strategy is to limit potential monopoly power.
|Since the 1960s, the U.S. Congress has enacted several programs to increase efficiencies in the labor market and allow workers to use their skills more fully. For example, it passed the Comprehensive Employment and Training Act (CETA) in 1973 and the Job Training Partnership Act in 1983. Some programs, such as the Job Corps and the Work Incentive Program, facilitated work apprenticeships.|
Traditional anti-inflation policies include preserving the purchasing power of incomes by restricting price and wage increases. These include the price guidelines the Johnson administration used, and the price and wage controls imposed during WW II and the Nixon administration. These controls were not effective due to expectations and many considered them too authoritarian in nature.
|Although price controls are more common in other countries than the United States, they were imposed during World War II, the Korean war, and the Nixon administration from 1971 to 1974. President Nixon imposed an unpopular 90-day freeze on wage and price increases in 1970 to counter inflation.|
Supply Side Economics
In early 1980s, President Ronald Reagan offered new policy to fight stagflation: cutting production costs by reducing the taxes and regulations government imposed on businesses. Since these policies reduced government revenue, they created a significant federal budget deficit.
|In 1977, Congress passed the Airline Deregulation Act to limit the power the U.S. Civil Aeronautics Board (CAB) had to set fares airlines could charge customers and assign the routes they could fly. They eventually dissolved the CAB in 1984. This deregulation increased competition among airlines, which encouraged them to reduce airfares by more than half. However, increased concentration of the airline industry during the 1990s has prompted airlines to increase their airfares.|
The Laffer curve depicts and increase in government revenues when it increases the tax rate from zero percent, or reduces it from 100 percent. Supply-side economists used this theory to defend a reduction in the tax rate on wealthy individuals, to increase government revenues. The high federal budget deficits that followed seemed to contradict the proposition the Laffer curve promoted.
|The Economic Recovery Act of 1981 cut the marginal tax rate on personal income taxes by 23 percent. The fact that revenues from personal income taxes hardly increased at all, seemed to confirm the argument the Laffer curve promoted. However, Congress did not adjust the tax brackets for inflation (bracket creep) until 1985, which may have been the reason revenues did not increase.|