1. From Stability to Inflation 1950-1980

2. After World War II? Post-World War II---all major economic powers except U.S. are devastated. U.S. has most of world’s gold supply and most of its productive capacity. What kind of monetary system? Classic Gold Standard----ensures long-term price stability and growth, but not short-term price stability. What’s the short-term. Two Problems: (1) No one, except U.S. has large gold reserves (2) Adjustment during 1929-1939 seems too slow and costly

3. The Bretton Woods Monetary System Abandon Classical Gold Standard Conference at Bretton Woods (1944): modified gold standard. U.S. has much of world’s monetary gold---so U.S.$ will be used as reserves in addition to gold.

4. The Bretton Woods Monetary System Dollars are to be freely convertible at one ounce = $35 for international transactions but not for domestic—holding gold coins illegal. U.S. is largest economy. Has large trade deficit-----buys goods and pays with dollars. Supports the revival of world’s economies. U.S. Balance of payments deficits leads to accumulation of dollar claims by foreign treasuries-----a slowly growing problem.

5. And the Fed? The Treasury-Federal Reserve Accord, 1951 The Federal Reserve regained its control over monetary policy After Korean War, budget roughly in balance and no fiscal shocks. The Fed targets nominal interest rates—raises them to counter inflation and lowers them to induce growth. William McChesney Martin---Chairman of the Fed 1951-1970

6. Price Stability & Growth in 1950s and early 1960s U.S. Budget is largely balanced. No external or internal shocks 1950s and 1960s are “quiet” price stability and financial stability But what is this trend

7. Legacy of the Great Depression: Belief in Activist Fiscal Policy Fear of unemployment. Keep it low. The Phillips Curve? Economists find a trade-off between inflation and unemployment. Paul Samuelson and Robert Solow (1960) identify 3% unemployment as goal but may have 6% inflation. Arthur Okun (1969) suggests 4% unemployment compatible with 2% inflation.

8. The Phillips Curve circa 1960

9. But the 1960s confound the curve What is going on????

10. But do we believe this now? What happened when inflation increased? Expectations alter the Phillips curve How? Increased demand (More spending or lower interest rates)  business hires more workers  drives up wages and prices & real costs, imagined profits vanish so reduce hiring Increased employment is temporary at best.

11. Inflationary Pressures Build in the 1960s: Vietnam War and Great Society spending

12. International Consequences Y = C + I + G + (X-M) And…..M = M(Y) while X = X(Yforeign) So if G is rising because of government spending on war and social security, medicare, and other programs and if C and I are rising because C = C(Y,i) and I =I(Y,i)  Large Trade Deficits, we pay in $US By 1966, foreign central banks and governments held over 14 billion U.S. dollars. The United States had $13.2 billion in gold reserves.

13. Collapse of Bretton Woods and Restraint on Inflation If all foreign central banks tried to convert their holdings at once, the United States would not be able to honor its obligations to convert $ into gold at $35 an ounce. Instead: a slow run on the dollar. But U.S. does not respond by tightened monetary policy------continued loss. Convertibility is suspended in August 1971 and officially in 1973---era of flexible exchange rates begins. Demand and Supply determine $ value------no anchor left for the dollar!! Faster inflation

14. Increased Inflationary pressures President Nixon attributed his defeat in 1960 to unwillingness of Eisenhower administration to stimulate economy even at risk of increasing inflation. Eager for 1972 election to have good economy. Pressure on Arthur Burns— new Chairman of the Fed Result is a monetary stimulus from the Fed----but inflation looms so price and wage controls are imposed Taught Milton Friedman at Rutgers

15. Increased Inflationary pressures Wage and Price Controls? What are the effects? Shortages!!!! Quickly Abandoned and with a Surge in Inflation!! Worse Yet? Oil price hikes 1973 & 1979---huge relative increase in commodity prices—the Fed is accommodative---keeps interest rates low  more monetary expansion. What do to?

16. 1979

17. October 6, 1979 High unemployment and high inflation---over 10%, no Phillips- Curve trade off. New chairman of the Federal Reserve—Paul Volcker. On Saturday October 6, 1979, the Fed announces it will target monetary aggregates and federal funds rate allowed to fluctuate. Bond prices collapse and interest rates jump  Real Interest Rates Jump. Economy moves into deep recession 1981-1982 but drives inflation down to 4%. Fed slackens Once inflation under control Fed changes to a policy of targeting the federal funds rate.

18. 1979 Result-----two severe recessions!!

19. Huge Cost to Drive Down Inflation: High Unemployment and First Financial Crisis Since the Great Depression

20. But no financial crisis for a long time after the New Deal. Why? 1929 and 1950: Frozen by the New Deal?

21. Liquidity Effects of the Great Depression and World War II---and the unwinding Number of Banks Total Assets $B Share in Loans % Share in Bonds % Share in Cash % Share in Other % 192924,9706258.121.014.56.5 193314,2074139.034.117.19.8 194014,5346825.035.3 4.4 194614,15215317.660.120.91.3 196013,50324347.730.919.32.1 198014,7291,44654.820.75.519.0

22. New Deal Restrictions Limits on Price Competition: Regulation Q Limits on Geographic Competition: Restrictions on Branching and Mergers Limits on Product Competition: Narrowly Defined Banking---new products limited Banks stay very profitable for a long time. BUT……THE RISE IN INFLATION AND THE EFFORT TO REDUCE INFLATION EXPLODES THIS SYSTEM