The Great Inflation was a period of high inflation between 1965 and 1982. In 1980, year-over-year inflation reached nearly 14.5%. As a result of the high inflation, Federal Reserve chair Paul Volcker raised the target federal funds rate to 20%.
The Great Inflation had several causes, including loose monetary policy by the Federal Reserve and increased government spending under presidents Lyndon B. Johnson and Richard Nixon.
After the Great Depression, Keynesian economic theory became prominent and widely adopted among economists and policy makers.
The basic idea of Keynesian counter-cyclical intervention was that economic crises are the result of deflation and a reduction in aggregate demand.
The cure for economic depressions and the recipe for ongoing prosperity, according to the theory, was to increase aggregate demand through fiscal and monetary stimulus.
Before the 1980s, Keynesian economists believed that rising prices and unemployment couldn’t co-exist. To reduce unemployment, central banks and governments could increase government spending and expand the money supply.
As long as full employment hadn’t been reached, inflation wouldn’t become a problem. Inflation would boost prosperity.
Once full employment was achieved, any additional increase in the general price level was unnecessary and unwanted. So as long as the economy hadn’t achieved full employment, inflation wasn’t an issue.
Based on this widely-believed theory, the Federal Reserve engaged in loose monetary policy.[1] Federal Reserve History: “The Great Inflation” Accessed June 6, 2022.
After the Great Depression, and once World War II ended, the Federal Reserve vowed to do more to stimulate the economy and reduce unemployment. The goal was to avoid another economic downturn similar to the Great Depression by fighting deflation and keeping the economy flush with “easy money”.
Between 1965 and 1979, the Federal Reserve let inflation run high without expecting any negative consequences.
The main reason Keynesian economists expected an inverse relationship between unemployment and inflation was due to something called the Phillips Curve.
The Phillips Curve, named after A. W. Phillips, states that with economic growth comes inflation. This inverse relationship between economic growth, most notably in the form of high employment rates, and inflation, was assumed until after the Great Inflation.
Milton Friedman and Edmund Phelps, among others, criticized the Phillips Curve. Friedman argued that high inflation would only work temporarily to stimulate economic growth.[2] Federal Reserve History: “The Great Inflation” Accessed June 6, 2022.
In the long-term, rising prices would lead to higher inflation expectations. This would weaken the stimulating effect of inflation, requiring ever more inflation to achieve the same result.[3] Milton Friedman: “Milton Friedman Speaks: Money and Inflation (B1230) – Full Video” Accessed June 6, 2022.
The Federal Reserve had to learn this the hard way during this challenging period. During the Great Inflation, the United States went through a period of stagflation.
Stagflation is a phenomenon that Keynesian economists thought was impossible. During stagflation, slow economic growth, high unemployment and high inflation all occur at the same time.
This phenomenon, which economists first observed in the 1970s, was inconsistent with traditional Keynesian theory.
Despite the Federal Reserve’s inflationary monetary policy, the economy stagnated and unemployment increased. In 1964, before the Great Inflation began, inflation was 1% and unemployment was 5%.
In 1974, ten years later, inflation was over 12% and unemployment was 7%. Half a decade later, in 1980, inflation was close to 14.5% and unemployment soared to 7.5%.[4] Federal Reserve History: “The Great Inflation” Accessed June 6, 2022.
These numbers were statistically incompatible with the Phillips Curve and the assumptions made by Keynesian economists at the time. The inverse relationship between inflation and unemployment, which mainstream economists assumed at the time, did not exist.
Apart from the Federal Reserve’s easy money policy, the US government significantly increased its fiscal spending under president Lyndon B. Johnson.
Johnson implemented several major spending programs under the label “Great Society”. The main goal of Johnson’s Great Society programs was the elimination of poverty and racial injustice in the United States.
It included major spending programs in the areas of education, medical care and transportation among others. This was consistent with Keynesian theory at the time, which called for government spending to increase aggregate demand in a way that free markets couldn’t on their own.
Johnson’s Great Society spending programs were the fiscal part of Keynesian stabilization policy. The Federal Reserve increased the money supply and engaged in inflationary monetary policy.
The US government, on the other hand, provided fiscal stimulus in the form of increased government spending. This combination of monetary and fiscal stimulus was thought to usher in a new era of ongoing prosperity after the Great Depression.
Additionally to Johnson’s Great Society spending programs, the United States spent significant amounts of money on the Vietnam war.[5] Federal Reserve History: “The Great Inflation” Accessed June 6, 2022.
Unlike World War I and II, which a majority of the American population backed, the Vietnam war was unpopular. The Untied States government mostly financed its involvement in World War I through domestic war bonds, known as Liberty Bonds.
World War II, one of the most expensive wars in history, was financed using income taxes and war bonds. After the attacks on Pearl Harbor, a majority of the population was in favor of the United States getting involved in World War II.
During the Vietnam war this was different. Instead of financing the Vietnam war through increased taxation or war bonds primarily sold to the population, the Federal Reserve created money and lent it to the government.
This creation of new money to finance the Vietnam war contributed to the Great Inflation.
The combination of Johnson’s spending programs and the growing cost of the Vietnam war pushed fiscal spending to high levels. As this money worked its way through the economy, it caused rising prices.
When president Nixon replaced Johnson, he implemented a series of policy changes that became known as the Nixon Shock.
Nixon imposed a 90-day wage and price freeze to combat rising prices.[6] Office of the Historian: “Nixon and the End of the Bretton Woods System, 1971–1973” Accessed June 6, 2022. Even more significantly, he closed the gold window and prevented foreign nations to convert their US dollars for gold.
President Franklin D. Roosevelt took the United States off the gold standard in 1933 when he issued Executive Order 6102.[7] The American Presidency Project. “Executive Order 6102—Requiring Gold Coin, Gold Bullion and Gold Certificates to Be Delivered to the Government” Accessed Feb. 24, 2022. After World War II, world leaders met in Bretton Woods, New Hampshire, to draft a new monetary system.
This monetary system got the name Bretton Woods system.
As part of the Bretton Woods system, the United States pegged the US dollar to gold at a fixed exchange rate.
All other nations pegged their currencies to the US dollar at relatively fixed exchange rates. This way, gold backed the US dollar directly and all other currencies indirectly.
The US dollar became world-reserve currency and all foreign nations held it in their reserves. They were promised they could exchange their dollars for gold at a fixed exchange rate any time.
Nixon sent shock waves throughout the international community when he broke this promise. By 1973, the Bretton Woods system was officially over.
The increased fiscal and monetary stimulus by the US government and Federal Reserve led to an increase in the money supply beyond the gold reserves the Untied States held.
The resulting Great Inflation made it impossible for the United States to continuously peg the US dollar to gold at a fixed exchange rate of $35 per ounce of gold.
The Great Inflation shattered trust in the US dollar as reserve currency and led to a run on US gold. Countries that were promised they could redeem their dollars for gold began demanding gold.
France even sent a war ship to New York to pick up its gold. The Great Inflation led to a drain of US gold reserves. To stop the outflow of gold, Nixon temporarily halted the Bretton Woods system. Global leaders drafted a new agreement, known as the Smithsonian agreement. But it failed shortly after its inception.
After the failure of the Smithsonian agreement, the Bretton Woods system officially ended in 1973.[8] Federal Reserve History: “The Smithsonian Agreement” Accessed June 6, 2022. From then on, all countries adopted floating exchange rates.
The collapse of the Bretton Woods system was both the result and partially the cause of the Great Inflation.
The Great Inflation made it impossible to maintain the US dollar peg of $35 per ounce of gold. The Federal Reserve and US government devalued the dollar as a result of its aggressive fiscal and monetary policies.
Once the world adopted floating exchange rates in 1973, the United States didn’t have to maintain a fixed exchange rate to gold. From that point onward, all currency became fiat currency. This made the US dollar subject to additional price increases.
The Federal Reserve and US government could inflate the US dollar without external constraints. And they continued doing so after facing a series of energy crises.
Throughout the 1970s the United States experienced two energy crises. The first one started with the Arab oil embargo in 1973.[9] Federal Reserve History: “The Great Inflation” Accessed June 6, 2022.
The Arab oil embargo, which lasted for five months, contributed to high oil prices. Crude oil prices quadrupled after 1973. In order to counteract the crisis caused by the embargo, the Federal Reserve continued loosening its monetary policy.
Instead of putting downward pressure on prices, this contributed to rising inflation. In 1979, the United States was hit by a second energy crisis linked to the Iranian revolution.
By 1980, the United States was facing double-digit inflation at almost 14.5%.[10] Federal Reserve Bank of St. Louis: “Consumer Price Index for All Urban Consumers: All Items in U.S. City Average” Accessed June 6, 2022.
Paul Volcker became chair of the Federal Reserve in 1979. He realized that getting the Great Inflation under control required decisive action.
In order to reduce inflation, Volcker raised the target federal funds rate to 20% in 1981.[11] Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed June 6, 2022. Additionally to raising the federal funds rate, the Federal Reserve began slowing down the creation of new reserves and broad money supply.
This led to a recession, once again intensifying the stagflation experienced during the Great Inflation. However, as a result of tightening monetary policy, general price levels eventually did drop.
The Great Inflation and subsequent stagflation invalidated traditional Keynesian stabilization policy and the Phillips Curve.
After the Great Inflation, the Federal Reserve began paying more attention to inflation. The idea that inflation could run high without negative consequences was set abandoned for good.
The Federal Reserve eventually implemented target inflation rate of 2%. Having an inflation target allowed the Fed to meet its dual mandate of price stability and full employment in a way that created some checks and balances around inflation.
The general Keynesian theory of counter-cyclical government spending and mild inflation as driver of prosperity is still prevalent today. However, monetarist theories, such as those of Milton Friedman, became more important as well.