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Worldwide Crop Failure
Nature dealt the first blow with worldwide crop failures in 1972 Intense worldwide demand for food took U.S. grain reserves from 830 million bushels to 265 million bushels in only 2 years. Food prices in the U.S. rose 20%. This worldwide crop failure begin the long inflationary spiral that was soon fully engaged (Stagflation - Videowww.learner.org)
The 1970's saw a different scourge influence the economic policy of the United States. In the past when inflation rose the Federal Reserve would increase interest rates to reduce aggregate demand (shift aggregate demand to the left) to push inflation down. When unemployment rose it used expansionary policy to increase demand (shifting the aggregate demand curve to the right) with subsequent aggregate price level increases. But the early 70's experienced ever increasing levels of inflation and higher unemployment combined together. This was unfamiliar territory. What was happening?
Nature dealt the first blow with worldwide crop failures in 1972 increasing world wide demand for food. U.S. grain reserves fell from 830 million bushels to 265 million bushels in only 2 years. Food prices in the U.S. rose 20%. This worldwide crop failure begin the long inflationary spiral that was soon fully engaged
& the Iranian Revolution
Paul Volcker as Chairman of the Federal Reserve is often credited for policies which ended the stagflation crisis of the 1970's. The Aggregate price level was rising rapidly. Paul Volcker chose to increase the quantity of money slowly. As the money in circulation declined demand for loans increased. The federal funds rate moved from an average of 11.5% pre Volcker up to 20% by 1981. This drove loan interest rates dramatically higher. The high rates of interest across the economy caused both investment and consumer spending to decline (reducing Aggregate Demand) squeezing inflation out of the economy (declining Aggregate Demand forced Aggregate Prices to stabilize or fall) , and changing the dynamics of inflationary expectations on the part of consumers and industry. By 1983 inflation had been reduced to 3.2 percent from a peak of 13.5%. Unemployment and a deep recession were the results of this policy and much economic pain was endured during this period. Volcker and his Federal Reserve board were the brunt of the most significant political attacks, protest, and derision ever directed at the Federal Reserve. (http://en.wikipedia.org/wiki/Paul Volcker en.wikipedia.org)
Now Paul Volcker is recognized and applauded for the efforts and policies he enacted with the Federal Reserve Board to combat the stagflation of the 70's. During his continued work until August 1987 when he was replaced by Alan Greenspan he maintained a sound approach to monetary and fiscal policy through his presidential and legislative influence and the powers vested in the "Fed". His approach led to a decades long period of steady growth, and restrained inflationary pressures.
Many alternative arguments have been made regarding the causes/sub-causes of the nature and extended duration of this period of inflation and unemployment. Some argue that significant expansion of the Money supply pre 70's into the 70's exacerbated the inflation issues. Others argue that large numbers of woman entering the labor market in the 70's contributed to the higher unemployment numbers. Nonetheless, current economic theory suggests that the negative supply shock of the oil embargo cast the U.S. economy into a spiral of unemployment and inflation where attempts to combat one only made the other worse. Inflation became a fixture in the economy. Inflation expectations rose and the Fed's credibility as an inflation fighter was being lost. Than the next negative supply shock hit. Enter the Iranian Revolution, the overthrow of the Shah of Iran, and the discontinuation of oil exports from Iran in 1979. Another supply shock and panic ensues. Prices skyrocket and fear and despair abound.
With the rapid rise in food prices and the added negative supply shock from the Arab Oil Embargo the U.S. entered into a period of extended inflation and unemployment. As shown in the diagram the Supply curve shifts to the left from the negative supply (Oil) resulting in increased Aggregate Price Levels through the economy (Oil is a commodity used in many industrial and consumer processes). At the same time Aggregate Output declines. This is Stagflation. (Graphically illustrated below from Krugman, "Macroeconomics", Third Ed., page 363.)
This was a different source of inflation than what
had traditionally occurred in the past. Past inflation had resulted from excessive rapid growth of Aggregate Demand where Demand outstripped what Production could ordinarily provide. Aggregate Demand shifts to the right, pushing up prices (inflation), and at least temporarily reducing unemployment. The classic of too much money chasing too few goods, until the economy adjusts (graphically illustrated below from Krugman, "Macroeconomics", Third Ed., p. 367.
In 1973, Egypt and Syria launched a surprise attack on Israel. The US supported Israel with weapons and re-supply. To express their collective displeasure Arab oil producers established an oil embargo against the U.S. and others who supported Israel. The U.S imported about 27% of its oil at the time, with enough of that coming from Arab producers to upset the availability of quantity demanded by industry and consumers (1973 oil crisis - Wikipedia, en.wikipedia.org). Many view this event as the supply shock which begin the cycle of stagflation. But, their was an earlier event which started pushing inflation upward.....