Case Study: The Great Inflation of the 1970s
From the mid-1960s to 1980, US inflation ratcheted from low single digits into double digits, peaking near 14 to 15 percent in early 1980. This episode shows three forces working together. Accommodative money growth by the Federal Reserve supplied the underlying fuel, two cost-push oil supply shocks (the 1973 OPEC embargo and the 1979 Iranian Revolution) jolted the price level upward, and a stop-go policy pattern let inflation expectations drift higher and become un-anchored. The runaway inflation set up the Volcker disinflation that began in October 1979.
Why it matters
Supply shocks alone give a one-off jump in prices, not a decade of rising inflation. Sustained double-digit inflation needs money growth to validate it and expectations to keep climbing. When the Fed eased every time unemployment rose and tightened only weakly when inflation rose, the public learned to expect more inflation, so wage and price setting built it in and each new shock pushed inflation to a higher plateau.
Worked examples
The 1973 OPEC embargo roughly quadrupled the price of oil. Using the demand-pull versus cost-push distinction, explain why this alone need not cause a decade of double-digit inflation.
An oil shock is a cost-push event that shifts aggregate supply left, raising the price level and lowering output in a one-time adjustment. Inflation persists only if policymakers respond by expanding the money supply to fight the resulting unemployment. The accommodative money growth, not the embargo by itself, is what turned a price-level jump into ongoing high inflation.
Map the 1970s onto the four effects of higher money growth on interest rates. Why did nominal interest rates end the decade so high?
The liquidity effect lowers rates at first, but the income, price-level, and especially the expected-inflation (Fisher) effects push them up over time. As expected inflation climbed through the decade, the Fisher effect dominated, so nominal rates rose with it. By 1981 the federal funds rate reached roughly 19 percent as Volcker tightened against entrenched expectations.
Common mistakes
- ✗The oil shocks caused the Great Inflation. The embargoes raised the price level sharply, but cost-push shocks become sustained inflation only when accommodative money growth validates them.
- ✗High inflation was purely demand-pull from overheating. It was a mix of demand-pull pressure from loose policy and tight labour markets and cost-push pressure from oil and wages, amplified by rising expectations.
- ✗Inflation expectations are just a forecast and do not matter for actual inflation. Once expectations became un-anchored, they fed into wage and price setting, which made inflation self-perpetuating and costly to reverse.
Revision bullets
- •US inflation rose from low single digits to roughly 14 to 15 percent by early 1980
- •Three forces combined: accommodative money growth, two cost-push oil shocks (1973 and 1979), and un-anchored expectations under stop-go policy
- •The episode set up the Volcker disinflation that began in October 1979
Quick check
Why is accommodative money growth, rather than the oil embargoes alone, treated as the key driver of sustained 1970s inflation?
What does it mean that inflation expectations became un-anchored during the 1970s?
Connected topics
Sources
- Federal Reserve History: The Great InflationBryan, M. The Great Inflation, 1965-1982. Federal Reserve History, Federal Reserve Bank of Richmond. federalreservehistory.org/essays/great-inflationOrigins in excessive money growth, the role of oil shocks, peak inflation near 14 to 15 percent by 1980, and the Volcker disinflation.
- Mishkin (2018), Ch. 24Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.Demand-pull versus cost-push inflation, the role of accommodative monetary policy and expectations, and the 1970s as the canonical example.