Federal Reserve dilemma: 1974.(Instructor's Note)

Tuttle, Mark ; Stretcher, Robert

CASE DESCRIPTION

The primary subject matter of this case concerns the dilemma facing the Federal Reserve in the mid 1970s when inflation and unemployment were reaching high levels simultaneously. From a historical perspective, the levels of both inflation and unemployment were reaching post war record highs. Secondary issues examined include arguments about proper policies from a variety of economic modeling perspectives. This case has a difficulty level appropriate for upper-level undergraduate courses and perhaps first year masters' level courses, depending on prior monetary economics background of the student population. The case is designed to be taught in one class period and should require two hours of outside preparation by students.

CASE SYNOPSIS

The mid 1970s experienced a variety of economically profound events. Among these were post Vietnam volatility in U.S. markets, oil price shocks, economically questionable fiscal policies, middle-east unrest, and a period of high unemployment combined with high inflation, confounding the conventional economic wisdom of the day. This case presents background, data and commentary concerning this period, and tasks the reader with deriving "appropriate" policy responses by the Federal Reserve. Readers must discern the uniqueness of the situation from past history, reconcile conflicting policies that had been pursued in the past, either targeting high inflation or high unemployment (not both at the same time), and deal with policy prescriptions that differed among various policy objectives.

INSTRUCTORS' NOTES

Teaching Approach

We suggest using this case in conjunction with coverage of various theoretical perspectives on dealing with separate problems of unemployment and inflation. The textbook remedies are easy to absorb, but the dilemma posed by the case will highlight the conflicting policy prescriptions and introduce the traditional theoretical relationship between inflation and unemployment and the difficulty of dealing with both at the same time.

The case could be used at a variety of course levels, from a brief treatment in principles of economics to advanced Macro levels. The questions are structured to serve a variety of sophistication levels, and have the potential to promote lively discussion in class.

QUESTIONS

1. What happened to inflation and unemployment in 1973? Why was the situation in 1973 unique?

Both inflation and unemployment were rising through 1973. This situation had never occurred in recent U.S. macroeconomic history.

2. The Employment Act of 1946 instructed policy makers to ensure maximum employment and price stability. What is the dilemma that the Federal Reserve faced in 1974?

Utilizing the Phillips Curve, there is a negative relationship between inflation and unemployment in the short run. If the Federal Reserve decided to combat inflation, as it did in late 1973, this could have reduced employment. If the Federal Reserve moved to combat unemployment following the summer of 1974 and the side-effect was higher inflation. The dilemma for the Federal Reserve was identifying the most pressing problem to combat first, inflation or unemployment.

3. If you were in charge of the Federal Reserve, what policy would you advocate? Justify your answer? (Remember, your stated objectives are low unemployment and low inflation).

There is no correct answer. In the short run, any policy designed to combat either inflation or unemployment will aggravate the other. Using the Phillips Curve, there is a negative trade-off between the two in the short run. The objective of this question is to help students understand this trade-off. If the student elects contractionary monetary policy (reducing the growth rate of money) to combat inflation, unemployment may increase. Yet, choosing expansionary monetary policies to combat unemployment may create higher inflation in the short run.

4. The Federal Reserve responded to the rising unemployment in 1973 by loosening monetary policy. A few months later, they reversed course and tightened monetary policy to combat rising inflation, causing a massive recession. What problems might arise if market participants expected the Federal Reserve to succumb to political pressures and change course yet again and reduce the targeted federal funds rate in 1974 or 1975 in response to rising unemployment?

If the Feds vacillation caused an increase in market participants' inflation expectations, then we can experience an increase in unemployment and inflation. This is represented by an upward shift in the short-run Phillips Curve and a reduction in aggregate demand. The result would be a recession that is more severe by creating a rate of unemployment that is higher than would otherwise have existed.

Optional Questions:

5. Which is the greater evil--inflation or unemployment?

The instructor may pose this question to students prior to them answering the case questions. Given their answer to this question, the answers to the case questions should reflect their response.

Advanced Questions:

6. The Fed has three basic tools (reserve ratios, discount rate and open market operations [OMO]) and one rarely used mechanism (margin debt leverage factor) for affecting changes in the macroeconomy, as well as public statements hinting at changes in any of the above. What is the nature of these tools relative to the specific problems present in the economy in 1974?

The Fed can affect system-wide monetary activity with the three policy tools, none of which address specific economic issues. Fiscal policy is much more likely to address specific problems (targeted tax law changes, targeted spending decisions), but the process involves a congressional accord concerning what is wrong and what should be done to fix it--unlikely when political bickering occurs (heightened in 1974).

However, if the only tool you have is a hammer (the general Fed treatments), every problem looks like a nail, even if what you really need to address the specific problem is a saw. This creates obvious side effects when a general policy is implemented in response to a specific problem. Professors can use this question to discuss some specific problems (like oil price spikes) and the inability of the Fed to directly address targeted problems.

EPILOGUE

Starting in the fall of 1973, the Federal Reserve Open Market Committee (FOMC) began to loosen monetary policy in response to the slowing economy, and the Federal Funds Rate fell. However, by the spring of 1974 the FOMC reversed its policy in response to rising inflation at the end of 1973 and beginning of 1974. The effective Federal Funds Rate began to rise. In July 1974 the effective Federal Funds Rate averaged 12.92 percent, signaling the Federal Reserve's commitment to combat inflation.

Through 1974, unemployment rose and aggregate output fell, as the U.S. economy sank deeper into recession. At the end of 1974, unemployment reached 7.2 percent. The FOMC once again reversed itself and eased monetary policy, expanding the money supply. The effective Federal Funds rate fell sharply, reaching 7.13 percent by the end of 1974 and under five percent at the end of 1975. Thus, the Federal Reserve chose to fight slow growth and high unemployment. The result was larger increases in price through 1974. Consumer prices increased over ten percent during 1974.

The price increases diminished during 1975 as the effects of the oil embargo on the U.S. economy eased. Thus, the Federal Reserve's goal of combating unemployment appeared to be the "correct" decision, although actual inflation remained high relative to historical inflation. In addition, unemployment fell slowly through 1975, and the recession reached its trough during the first quarter of 1975. For the remaining three quarters of 1975 real output grew 5.1 percent and unemployment fell to 7.9 percent by the start of 1976.

REFERENCES

Board of Governors of the Federal Reserve System. Retrieved August 30, 2007 from http://www.federalreserve.gov/releases/z1/Current/data.htm.

Federal Reserve Bank of St. Louis. Retrieved August 20, 2007 from http://research.stlouisfed.org/fred2/.

Mark Tuttle, Sam Houston State University

Robert Stretcher, Sam Houston State University