Economics Essays - Inflation

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While economists debate the relative importance of the factors that motivated and perpetuated inflation for more than a decade, there is little debate about its source.But the stability of the Phillips curve was a fateful assumption, one that economists Edmund Phelps (1967) and Milton Friedman (1968) warned against.Said Phelps “[I]f the statical ‘optimum’ is chosen, it is reasonable to suppose that the participants in product and labour markets will learn to expect inflation…and that, as a consequence of their rational, anticipatory behaviour, the Phillips Curve will gradually shift upward...” (Phelps 1967; Friedman 1968).The Great Inflation was the defining macroeconomic period of the second half of the twentieth century.Lasting from 1965 to 1982, it led economists to rethink the policies of the Fed and other central banks.In other words, the trade-off between lower unemployment and more inflation that policymakers may have wanted to pursue would likely be a false bargain, requiring ever higher inflation to maintain.Chasing the Phillips curve in pursuit of lower unemployment could not have occurred if the policies of the Federal Reserve were well-anchored.If the Great Inflation was a consequence of a great failure of American macroeconomic policy, its conquest should be counted as a triumph.In 1964, inflation measured a little more than 1 percent per year.As the world’s reserve currency, the US dollar had an additional problem. As inflation drifted higher during the latter half of the 1960s, US dollars were increasingly converted to gold, and in the summer of 1971, President Nixon halted the exchange of dollars for gold by foreign central banks.Over the next two years, there was an attempt to salvage the global monetary system through the short-lived Smithsonian Agreement, but the new arrangement fared no better than Bretton Woods and it quickly broke down. With the last link to gold severed, most of the world’s currencies, including the US dollar, were now completely unanchored.

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