Federal Reserve Bank of San Francisco

FRBSF Economic Letter

1998-14 | May 1, 1998

More Economic Letters

The Shadow of the Great Depression and the Inflation of the 1970s

J. Bradford DeLong

The inflation of the 1970s was a time when uncertainty about prices made every business decision a speculation on monetary policy. During that decade, the annual U.S. inflation rate rose in the 5-10% range, compared to a 0-3% range typical of peacetime America.

If you asked a representative sample of economists why there is inflation, many would refer you to Kydland and Prescott (1977). They argue that higher than desirable inflation springs from the inability of central bankers to commit themselves to low-inflation policies. Central banks benefit when workers, firms, and investors have confidence that inflation will be low; but they also benefit–production is higher and unemployment is lower–when inflation turns out to be a little bit higher than expected. Thus workers, firms, and investors lack complete confidence in declarations that policy is to keep inflation low.

But this explains why inflation might be higher than desirable in general. It does not explain why inflation would be higher than desirable for one particular decade–the 1970s–while remaining low in the surrounding decades of the 1950s, the 1960s, the 1980s, and the 1990s.

Thus, it is necessary to look elsewhere, and looking elsewhere leads to the conclusion that the inflation of the 1970s had three causes, depending on how deeply one wishes to look at the underlying situation. (These issues and more detail on the history of the period are in DeLong 1997.)

At the first surface level, the U.S. had a burst of inflation in the 1970s because until the 1980s no influential policymakers–until Paul Volcker became Chairman of the Federal Reserve-placed a sufficiently high priority on stopping inflation; other goals took precedence. At the second deeper level, the U.S. had a burst of inflation in the 1970s because economic policymakers during the 1960s dealt their successors a bad hand. And bad cards coupled with bad luck made inflation in the 1970s worse than anyone expected it might be. At the third level, the most profound cause of the inflation of the 1970s was the shadow cast by the Great Depression-an event that made it impossible for a while to believe that the business cycle was a fluctuation around, rather than a shortfall below, potential output and employment. Only after the experiences of the 1970s were policymakers persuaded that the minimum sustainable rate of unemployment attainable by macroeconomic policy was relatively high, and that the costs-at least the political costs-of even moderately high one-digit inflation were high as well.

Inflation reduction: A low priority

By the end of the 1960s, the U.S. had finished its experiment to see if it was possible to push unemployment below 4% without accelerating inflation. The answer was “no.” Nonfarm nominal wage growth had fluctuated around or below 4% per year between the end of the Korean War and the mid-1960s, and by 1968 it was more than 6% and rising.

Could U.S. monetary policy have responded to rising wage inflation at the end of the 1960s, and ended the inflation of the 1970s before it started? At a technical level, yes. For example, Germany managed it: Germany’s inflation peaked at the very beginning of the 1970s, at which point the Bundesbank made inflation reduction its first priority; by the mid-1970s, its cyclical peak was lower than the 1971 peak, and the early 1980s peak is invisible.

But in the U.S. there were obstacles. One was Richard Nixon, who was wary of policies to reduce inflation at the potential cost of higher unemployment. Nixon attributed his defeat in 1960 to Eisenhower’s unwillingness to stimulate employment at the risk of increasing inflation (Nixon 1962). Thus, during his presidency he authorized his labor secretary to declare that his administration would “control inflation without a rise of unemployment” (Stein 1984).

A second obstacle was that Federal Reserve Chair Arthur Burns was skeptical about the value of using monetary policy to control inflation in the postwar era. In Burns (1960), he noted that “During the postwar recessions the average level of prices in wholesale and consumer markets has declined little or not at all,” and he cited several factors-including a sharp rise in long-term interest rates and an “abnormally low” yield on stocks relative to bonds-that appeared to be “symptoms of a continuation of inflationary expectations or pressures.” Before World War II such inflationary expectations and pressures would have been erased by a severe recession and by the pressure put on workers’ wages and manufacturers’ prices by falling aggregate demand. But Burns could not see how such pressures to moderate wage increases could be generated in the postwar world in which workers and firms rationally expected recessions to be short and shallow.

Third, there was no political support anywhere else for a policy of reducing inflation first. Congressional Republicans did not call for more aggressive fights against inflation. And Democrats complained that the Nixon administration policy was too contractionary.

Indeed, only with the acceleration of inflation at the end of the 1970s did political sentiment begin to shift. By the time Paul Volcker became Chairman of the Federal Reserve, inflation reduction-rather than full employment-had become the highest priority. The Volcker-led Fed quickly signaled its intention to place first priority on controlling inflation by shifting its operating procedures to place a greater emphasis on money supply targets.

Bad luck during the 1970s

On top of the unwillingness to give inflation reduction high priority came bad luck. Alan Blinder (1982) has argued that double-digit inflation in the 1970s had a single cause: supply shocks that sharply increased the nominal prices of a few categories of goods. But those in the monetarist tradition never found this explanation convincing. As Milton Friedman (1975) said: “The special conditions that drove up the price of oil and food required purchasers to spend more on them, leaving them less to spend on other items. Did that not force other prices to go down, or to rise less rapidly than otherwise? Why should the average level of prices be affected significantly by changes in the price of some things relative to others?”

Ball and Mankiw (1995) believe the missing link is to be found in menu-cost models of aggregate supply. Firms and workers adjust their prices and wages to large economic changes, but ignore small ones because it is not worthwhile to figure out how to respond to them. Thus, a concentrated sharp increase in the nominal prices of a few commodities produces a much larger effect on the average level of prices and inflation than a more diffused increase in the nominal prices of money commodities.

But U.S. inflation in the 1970s was not solely the result of supply shocks. Taking the rate of wage inflation at the start of the 1970s and adding the effects of the 1970s productivity slowdown on the difference between wage and price inflation gives a baseline price inflation rate of 7% per year at the end of the 1970s without including any persistent effect of supply shocks. The contribution of bad luck during the 1970s is less than the contribution of the situation at the start of the decade.

The shadow of the Great Depression

It is not enough to explain the inflation of the 1970s to say that the U.S. economy had bad luck during the 1970s, that the political consensus to support a policy of inflation reduction did not exist until the very end of the 1970s, and that economic policymakers in the 1960s dealt their successors a bad hand. The questions remain: Why did the political consensus to reduce inflation not exist until the end of the 1970s? And why did makers of economic policy during the 1960s watch with little concern as inflation crept upward, and as expectations of rising rates of price inflation became embedded in labor contracts and firm operating procedures?

The source of these attitudes and frames of mind is, in a strong sense, the most profound cause of the inflation of the 1970s. And that source is the shadow cast by the Great Depression. The extraordinarily high unemployment of the Great Depression made it very difficult to believe that the business cycle was a fluctuation around a growing level of potential output and sustainable employment. Instead, the Great Depression created a strong presumption that business cycles were shortfalls below potential output and sustainable employment. In the context of the Great Depression, it seemed absurd to take the average level of capacity utilization or unemployment achieved as a measure of the economy’s sustainable productive potential.

In the shadow of the Great Depression, economists thought of fiscal and monetary policy in terms of “closing the gap” between actual and potential output, not in terms of moderating fluctuations around some long-run trend. But how were makers of fiscal and monetary policy to know when they had “closed the gap” and attained the maximum sustainable level of employment and capacity utilization? Neither economic theory nor economic history gave guidance, so there was a strong tendency to rely on hope and optimism.

Thus, in the early 1960s, economists as prominent as Paul Samuelson and Robert Solow (1960) could write of a 4% “interim” target for the unemployment rate that should be achieved. Moreover, they saw no reason that the “final” target for unemployment might not be even lower. The hope that unemployment could be pushed lower than the U.S. economy had ever achieved before without producing unacceptable consequences for the rate of inflation was reinforced by A.W. Phillips’s study of inflation and unemployment in the United Kingdom late 1950s. This “Phillips curve” appeared to show a stable, unchanging relationship between inflation and unemployment.

The temptation to believe that Phillips’s results were robust and could be generalized was very strong. The average level of capacity utilization and the unemployment rate were not guides to the long-run sustainable level, so there was an overwhelming temptation to “close the gap”–to see if unemployment could not be pushed even lower and capacity utilization higher. Politicians and their advisors had very strong incentives to believe that the Phillips curve taught that unemployment below 4% could be sustained indefinitely. Only the experience of the end of the 1960s and 1970s–when attempts to sustain low unemployment generated strongly accelerating inflation, as Milton Friedman (1968) had predicted it would–could change people’s minds.

Thus there is a strong sense that something like the inflation of the 1970s was nearly inevitable. Had macroeconomic policy been less stimulative in the 1960s, and had inflation been lower at the end of that decade, there still would have been calls for increasing efforts to reduce unemployment in the 1970s.

Only after the experiences of the 1970s were policymakers persuaded that the flaws and frictions in American labor markets made it unwise to try to use stimulative macroeconomic policies to push the unemployment rate down to a very low level and to hold it there.

J. Bradford DeLong
Associate Professor, U.C. Berkeley
and Visiting Scholar, FRBSF


Ball, Laurence, and N. Gregory Mankiw. 1995. “Relative Price Changes as Aggregate Supply Shocks.” Quarterly Journal of Economics 110, pp. 161-193.

Blinder, Alan. 1982. “The Anatomy of Double-Digit Inflation in the 1970s.” In Inflation: Causes and Effects, ed. R.E. Hall, pp. 261-282. Chicago: University of Chicago Press.

Burns, Arthur. 1960. “Progress towards Economic Stability.” American Economic Review 50, pp. 1-19.

DeLong, J. Bradford. 1997. “America’s Peacetime Inflation: The 1970s.” In Reducing Inflation: Motivation and Strategy, eds. Christina Romer and David Romer. Chicago: University of Chicago Press.

Friedman, Milton. 1975. “Perspectives on Inflation.” Newsweek (June 24) p. 73.

Friedman, Milton. 1968. “The Role of Monetary Policy.” American Economic Review 58 (1) pp. 1-17.

Kydland, Finn, and Edward Prescott. 1977. “Rules Rather Than Discretion: The Inconsistency of Optimal Plans.” Journal of Political Economy 87 (June) pp. 473-492.

Nixon, Richard. 1962. Six Crises. New York: Doubleday.

Samuelson, Paul, and Robert Solow. 1960. “Analytical Foundations of Anti-Inflation Policy.” American Economic Review 50 (May) pp. 185-197.

Stein, Herbert. 1984. Presidential Economics. New York: Simon and Schuster.

Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Sam Zuckerman and Anita Todd. Permission to reprint must be obtained in writing.

Please send editorial comments and requests for reprint permission to
Research Library
Attn: Research publications, MS 1140
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120