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Inflation

With this macroeconomic reinterpretation, Figure 1(b) depicts the problem of inflation. We see from the figure that the outward shift of the aggregate demand curve, whatever its cause, pushes the price level up. If aggregate demand keeps shifting out month after month, the economy will suffer from inflation—meaning a sustained increase in the general price level.

Inflation refers to a sustained increase in the general price level.

Recession and Unemployment

The second principal issue of macroeconomics, recession and unemployment, also can be illustrated on a supply-demand diagram, this time by shifting the demand curve in the opposite direction. Figure 2 repeats the supply and demand curves of Figure 1(a) and in addition depicts a leftward shift of the aggregate demand curve from D0D0 to D2D2. Equilibrium now moves from point E to point B so that domestic product (total output) declines. This is what we normally mean by a recession—a period of time during which production falls and people lose jobs.

Economic Growth

Figure 3 illustrates macroeconomists’ third area of concern: the process of economic growth. Here the original aggregate demand and supply curves are, once again, D0D0 and S0S0, which intersect at point E. But now we consider the possibility that both curves shift to the right over time, moving to D1D1 and S1S1, respectively. The new intersection point is C, and the brick-colored arrow running from point E to point C shows the economy’s growth path. Over this period of time, domestic product grows from Q0 to Q1.

A recession is a period of time during which the total output of the economy declines.

FIGURE 2	FIGURE 3
An Economy Slipping into a Recession	Economic Growth

	D0	S
	D2
Level		E
Price	B
		D0
	S
		D2
	Q2	Q0

Domestic Product

	D1	S0
		S1
	D0
Price Level	E
	S0
		D1
	S1
		D0
	Q0	Q1

Domestic Product

GROSS DOMESTIC PRODUCT

Up to now, we have been somewhat cavalier in using the phrase “domestic product.” Let’s now get more specific. Of the various ways to measure an economy’s total output,

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Gross domestic product (GDP) is the sum of the money values of all final goods and services produced in the domestic economy and sold on organized markets during a specified period of time, usually a year.

the most popular choice by far is the gross domestic product, or GDP for short—a term you have probably encountered in the news media. GDP is the most comprehensive measure of the output of all the factories, offices, and shops in the United States. Specifically, it is the sum of the money values of all final goods and services produced in the domestic economy within the year.

Several features of this definition need to be underscored.2 First, you will notice that

We add up the money values of things.

Nominal GDP is calculated by valuing all outputs at current prices.

Real GDP is calculated by valuing outputs of different years at common prices.

Therefore, real GDP is a far better measure than nominal GDP of changes in total production.

Money as the Measuring Rod: Real versus Nominal GDP

The GDP consists of a bewildering variety of goods and services: computer chips and potato chips, tanks and textbooks, ballet performances and rock concerts. How can we combine all of these into a single number? To an economist, there is a natural way to do so: First, convert every good and service into money terms, and then add all the money up. Thus, contrary to the cliché, we can add apples and oranges. To add 10 apples and 20 oranges, first ask: How much money does each cost? If apples cost 20 cents and oranges cost 25 cents, then the apples count for $2 and the oranges for $5, so the sum is $7 worth of “output.” The market price of each good or service is used as an indicator of its value to society for a simple reason: Someone is willing to pay that much money for it.

This decision raises the question of what prices to use in valuing different outputs. The official data offer two choices. Most obviously, we can value each good and service at the price at which it was actually sold. If we take this approach, the resulting measure is called nominal GDP, or GDP in current dollars. This seems like a perfectly sensible choice, but it has one serious drawback as a measure of output: Nominal GDP rises when prices rise, even if there is no increase in actual production. For example, if hamburgers cost $2.00 this year but cost only $1.50 last year, then 100 hamburgers will contribute $200 to this year’s nominal GDP, whereas they contributed only $150 to last year’s nominal GDP. But 100 hamburgers are still 100 hamburgers—output has not grown.

For this reason, government statisticians have devised alternative measures that correct for inflation by valuing goods and services produced in different years at the same set of prices. For example, if the hamburgers were valued at $1.50 each in both years, $150 worth of hamburger output would be included in GDP in each year. In practice, such calculations can be quite complicated, but the details need not worry us in an introductory course. Suffice it to say that, when the calculations are done, we obtain real GDP or GDP in constant dollars. The news media often refer to this measure as “GDP corrected for inflation.” Throughout most of this book, and certainly whenever we are discussing the nation’s output, we will be concerned with real GDP.

The distinction between nominal and real GDP leads us to a working definition of a recession as a period in which real GDP declines. For example, between the fourth quarter of 2000 and the third quarter of 2001, America’s last recession, nominal GDP rose from $9,954 billion to $10,135 billion, but real GDP fell from $9,888 billion to $9,871 billion. In fact, it has become conventional to say that a recession occurs when real GDP declines for two or more consecutive quarters.

What Gets Counted in GDP?

The next important aspect of the definition of GDP is that

The GDP for a particular year includes only goods and services produced within the year. Sales of items produced in previous years are explicitly excluded.

2 Certain exceptions to the definition are dealt with in the appendix to Chapter 8. Some instructors may prefer to take up that material here.

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For example, suppose you buy a perfectly beautiful 1985 Thunderbird from a friend next week and are overjoyed by your purchase. The national income statistician will not share your glee. She counted that car in the GDP of 1985, when it was first produced and sold, and will never count it again. The same is true of houses. The resale values of houses do not count in GDP because they were counted in the years they were built.

Next, you will note from the definition of gross domestic product that

Only final goods and services count in the GDP.

The adjective final is the key word here. For example, when Dell buys computer chips from Intel, the transaction is not included in the GDP because Dell does not want the chips for itself. It buys them only to manufacture computers, which it sells to consumers. Only the computers are considered a final product. When Dell buys chips from Intel, economists consider the chips to be intermediate goods. The GDP excludes sales of intermediate goods and services because, if they were included, we would wind up counting the same outputs several times.3 For example, if chips sold to computer manufacturers were included in GDP, we would count the same chip when it was sold to the computer maker and then again as a component of the computer when it was sold to a consumer.

Next, note that

The adjective domestic in the definition of GDP denotes production within the geographic boundaries of the United States.

Some Americans work abroad, and many American companies have offices or factories in foreign countries. For example, roughly half of IBM’s employees work outside the United States. While all of these foreign employees of American firms produce valuable outputs, none of it counts in the GDP of the United States. (It counts, instead, in the GDPs of the other countries.) On the other hand, quite a few foreign companies produce goods and services in the United States. For example, if your family owns a Toyota or a Honda, it was most

likely assembled in a factory here. All that activity of foreign firms on our soil does count in our GDP.4

Finally, the definition of GDP notes that	Journal—	Syndicate.
For the most part, only goods and services that pass through organized	FromSOURCE:The Wall Street	CartoonPermission,Features
Garage sales, although sometimes lucrative, are not included either. The defi-
markets count in the GDP.
This restriction, of course, excludes many economic activities. For example,
illegal activities are not included in the GDP. Thus, gambling services in
Atlantic City are part of GDP, but gambling services in Chicago are not.

nition reflects the statisticians’ inability to measure the value of many of the economy’s most important activities, such as housework, do-it-yourself repairs, and leisure time. These activities certainly result in currently produced goods or services, but they all lack that important measuring rod—a market price.

This omission results in certain oddities. For example, suppose that each of two neighboring families hires the other to clean house, generously paying $1,000 per week for the services. Each family can easily afford such generosity because it collects an identical salary from its neighbor. Nothing real has changed, but GDP goes up by $104,000 per year. If this example seems trivial, you may be interested to know that,

Final goods and services are those that are purchased by their ultimate users.

An intermediate good is a good purchased for resale or for use in producing another good.

3Actually, there is another way to add up the GDP by counting a portion of each intermediate transaction. This is explained in the appendix to Chapter 8.

4There is another concept, called gross national product, which counts the goods and services produced by all Americans, regardless of where they work. For consistency, the outputs produced by foreigners working in the United States are not included in GNP. In practice, the two measures—GDP and GNP—are very close.

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according to one estimate made some years ago, America’s GDP might be a stunning 44 percent higher if unpaid housework were valued at market prices and counted in GDP.5

Limitations of the GDP: What GDP Is Not

Now that we have seen in some detail what the GDP is, let’s examine what it is not. In particular:

Gross domestic product is not a measure of the nation’s economic well-being.

The GDP is not intended to measure economic well-being and does not do so for several reasons.

Only Market Activity Is Included in GDP As we have just seen, a great deal of work done in the home contributes to the nation’s well-being but is not counted in GDP because it has no price tag. One important implication of this exclusion arises when we try to compare the GDPs of developed and less developed countries. Americans are always amazed to hear that the per-capita GDPs of the poorest African countries are less than $250 per year. Surely, no one could survive in America on $5 per week. How can Africans do it? Part of the answer, of course, is that these people are terribly poor. But another part of the answer is that

International GDP comparisons are vastly misleading when the two countries differ greatly in the fraction of economic activity that each conducts in organized markets.

This fraction is relatively large in the United States and relatively small in the poorest countries. So when we compare their respective measured GDPs, we are not comparing the same economic activities. Many things that get counted in the U.S. GDP are not counted in the GDPs of very poor nations because they do not pass through markets. It is ludicrous to think that these people, impoverished as they are, survive on what an American thinks of as $5 per week.

A second implication is that GDP statistics take no account of the so-called underground economy—a term that includes not just criminal activities, but also a great deal of legitimate business that is conducted in cash or by barter to escape the tax collector. Naturally, we have no good data on the size of the underground economy. Some observers, however, think that it may amount to 10 percent or more of U.S. GDP—and much more in some foreign countries.

GDP Places No Value on Leisure As a country gets richer, its citizens normally take more and more leisure time. If that is true, a better measure of national well-being that includes the value of leisure would display faster growth than conventionally measured GDP. For example, the length of the typical workweek in the United States fell steadily for many decades, which meant that growth in GDP systematically underestimated the growth in national well-being. But then this trend stopped and may even have reversed. (See “Are Americans Working More?” on the next page.)

“Bads” as Well as “Goods” Get Counted in GDP There are also reasons why the GDP overstates how well-off we are. Here is a tragic example. Disaster struck the United States on September 11, 2001. No one doubts that this made the nation worse off. Thousands of people were killed. Buildings and businesses were destroyed. Yet the disaster almost certainly raised GDP. The government spent more for disaster relief and cleanup, and later for reconstruction. Businesses spent more to rebuild and repair damaged buildings and replace lost items. Even consumers spent more on cleanup and replacing lost possessions. No one imagines that America was better off after 9/11, despite all this additional GDP.

5 Ann Chadeau, “What Is Households’ Non-Market Production Worth?” OECD Economic Studies, 18 (1992), pp. 85–103.

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Are Americans Working More?

According to conventional wisdom, the workweek in the United States is steadily shrinking, leaving Americans with more and more leisure time to enjoy. But a 1991 book by economist Juliet Schor pointed out that this view was wrong: Americans were really working longer and longer hours. Her findings were both provocative and controversial at the time. But since then, the gap between the typical American and European workweeks has widened.

In the last twenty years the amount of time Americans have spent at their jobs has risen steadily. . . . Americans report that they have only sixteen and a half hours of leisure a week, after the obligations of job and household are taken care of. . . . If present trends continue, by the end of the century Americans will be spending as much time at their jobs as they did back in the nineteen twenties.

The rise in worktime was unexpected. For nearly a hundred years, hours had been declining. . . . Equally surprising, but also hardly recognized, has been the deviation from Western Europe. After progressing in tandem for nearly a century, the United States veered off into a trajectory of declining leisure, while in Europe work has been disappearing. . . . U.S. manufacturing employees currently work 320 more hours [per year]—the equivalent of over two months—than their counterparts in West Germany or France. . . . We have paid a price for prosperity. . . .

We are eating more, but we are burning up those calories at work. We have color televisions and compact disc players, but we need them to unwind after a stressful day at the office. We take vacations, but we work so hard throughout the year that they become indispensable to our sanity.

SOURCE: © Comstock Images/Getty Images

SOURCE: Juliet B. Schor, The Overworked American (New York: Basic Books; 1991), pp. 1–2, 10–11.

Wars represent an extreme example. Mobilization for a war fought on some other nation’s soil normally causes a country’s GDP to rise rapidly. But men and women serving in the military could be producing civilian output instead. Factories assigned to produce armaments could instead be making cars, washing machines, and televisions. A country at war is surely worse off than a country at peace, but this fact will not be reflected in its GDP.

Ecological Costs Are Not Netted Out of the GDP Many productive activities of a modern industrial economy have undesirable side effects on the environment. Automobiles provide an essential means of transportation, but they also despoil the atmosphere. Factories pollute rivers and lakes while manufacturing valuable commodities. Almost everything seems to produce garbage, which creates serious disposal problems. None of these ecological costs are deducted from the GDP in an effort to give us a truer measure of the net increase in economic welfare that our economy produces. Is this omission foolish? Not if we remember that national income statisticians are trying to measure economic activity conducted through organized markets, not national welfare.

Now that we have defined several of the basic concepts of macroeconomics, let us breathe some life into them by perusing the economic history of the United States.

THE ECONOMY ON A ROLLER COASTER

Growth, but with Fluctuations

The most salient fact about the U.S. economy has been its seemingly limitless growth; it gets bigger almost every year. Nominal gross domestic product in 2007 was around $13.8 trillion, more than 27 times as much as in 1959. The black curve in Figure 4 shows

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FIGURE 4

Nominal GDP, Real GDP, and Real GDP per Capita Since 1959

												$14,000
	$45,000
												$13,000
	$40,000											$12,000
												$11,000
	35,000
												$10,000
Year	30,000			Real GDP per capita (left scale)								$9,000
												8,000
per
	25,000
Dollars												7,000
	20,000											6,000
												5,000
	15,000
												4,000
				Real GDP
	10,000			(right scale)								3,000
						Nominal GDP (right scale)						2,000
	5,000
												1,000
	0											0
	1955	1960	1965	1970	1975	1980	1985	1990	1995	2000	2005	2010
						Year

NOTE: Real GDP figures are in 2000 dollars.

Dollars per Year		U.S. Government Printing Office, various years).
Billions of		(Washington, D.C.:
		SOURCE: Economic Report of the President

Real GDP per capita is the ratio of real GDP divided by population.

that extraordinary upward march. But, as the discussion of nominal versus real GDP suggests, a large part of this apparent growth was simply inflation. Because of higher prices, the purchasing power of each 2007 dollar was less than one-fifth of each 1959 dollar. Corrected for inflation, we see that real GDP (the blue curve in the figure) was only about 4 3⁄4 times greater in 2007 than in 1959.

Another reason for the growth of GDP is population growth. A nation becomes richer only if its GDP grows faster than its population. To see how much richer the United States has actually become since 1959, we must divide real GDP by the size of the population to obtain real GDP per capita—which is the brick-colored line in Figure 4. It turns out that real output per person in 2007 was roughly 2.8 times as much as in 1959. That is still not a bad performance.

If aggregate supply and demand grew smoothly from one year to the next, as was depicted in Figure 3, the economy would expand at some steady rate. But U.S. economic history displays a far less regular pattern—one of alternating periods of rapid and slow growth that are called macroeconomic fluctuations, or sometimes just business cycles. In some years—five since 1959, to be exact—real GDP actually declined.6 Such recessions, and their attendant problem of rising unemployment, have been a persistent feature of American economic performance—one to which we will pay much attention in the coming chapters.

The bumps encountered along the American economy’s historic growth path stand out more clearly in Figure 5, which displays the same data in a different way and extends the time period back to 1870. Here we plot not the level of real GDP each year, but, rather, its growth rate—the percentage change from one year to the next. Now the booms and busts that delight and distress people—and swing elections—stand out clearly. For example, the

6 The 2001 recession was so mild that real GDP for the full year 2001 was actually higher than in 2000.

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FIGURE 5

The Growth Rate of U.S. Real Gross Domestic Product since 1870

1929.

Rapid

World

sincedataDepartmentCommercefromauthorstheby

GDPRealofRateGrowthPercentage

industrialization

Romer.ChristinaProfessorbyresearchonbasedare

20

of 1907

Roaring

War II

recession

Post–1950

Pre–1940

Korean

Twenties

War

15

Railroad

World

Expansion

Expansion

Boom

prosperity

War I

of

of

of

10

1960s

1980s

1990s

5

0

–5

1974–75

1990–91

Recession

Recession

Depression

Postwar

1982–83

–10

of 1890s

depression

Recession

Panic

Postwar

Constructed

1869–1928

–15

Great

2007

–20

Depression

SOURCE:

Datafor

1870

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

Year

fact that real GDP grew by over 7 percent from 1983 to 1984 helped ensure Ronald Reagan’s landslide reelection. Then, from 1990 to 1991, real GDP actually fell by 1 percent, which helped Bill Clinton defeat George H. W. Bush. On the other hand, weak economic growth from 2000 to 2004 did not prevent George W. Bush’s reelection.

Inflation and Deflation

The history of the inflation rate depicted in Figure 6 also shows more positive numbers than negative ones—more inflation than deflation. Although the price level has risen roughly 16-fold since 1869, the upward trend is of rather recent vintage. Prior to World

Deflation refers to a sustained decrease in the general price level.

		FIGURE 6
		The Inflation Rate in the United States since 1870
1929.
dataDepartmentCommercefromauthorsthebysince	Romer.ChristinaProfessorbyresearchonbasedare						World			World
		RateInflationPercentage	25	Post-Civil War						War II
							War I
			20									Postwar
				Pre–1940							adjustment
			15										Inflation
													of the 1970s
			10												Disinflation
															of the 1980s
			5
			0
														Vietnam War
			–5											inflation
												Post–1950
Constructed	1869–1928		–10	deflation			Postwar			Great						2007
						deflation				Depression
			–15
SOURCE:	Datafor		1870	1880	1890	1900	1910	1920	1930	1940	1950	1960	1970	1980	1990	2000
										Year

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War II, Figure 6 shows periods of inflation and deflation, with little or no tendency for one to be more common than the other. Indeed, prices in 1940 were barely higher than those at the close of the Civil War. However, the figure does show some large gyrations in the inflation rate, including sharp bursts of inflation during and immediately after the two world wars and dramatic deflations in the 1870s, the 1880s, 1921–1922, and 1929–1933. Recently, as you can see, inflation has been both low and stable.

In sum, although both real GDP, which measures the economy’s output, and the price level have grown a great deal over the past 138 years, neither has grown smoothly. The ups and downs of both real growth and inflation are important economic events that need to be explained. The remainder of Part 2, which develops a model of aggregate supply and demand, and Part 3, which explains the tools the government uses to try to manage aggregate demand, will build a macroeconomic theory designed to do precisely that.

The Great Depression

As you look at these graphs, the Great Depression of the 1930s is bound to catch your eye. The decline in economic activity from 1929 to 1933 indicated in Figure 5 was the most severe in our nation’s history, and the rapid deflation in Figure 6 was extremely unusual. The Depression is but a dim memory now, but those who lived through it—including some of your grandparents—will never forget it.

Human Consequences Statistics often conceal the human consequences and drama of economic events. But in the case of the Great Depression, they stand as bitter testimony to its severity. The production of goods and services dropped an astonishing 30 percent, business investment almost dried up entirely, and the unemployment rate rose ominously from about 3 percent in 1929 to 25 percent in 1933—one person in four was jobless! From the data alone, you can conjure up pictures of soup lines, beggars on street corners, closed factories, and homeless families. (See “Life in ‘Hooverville.’”)

Life in “Hooverville”

During the worst years of the Great Depression, unemployed workers congregated in shantytowns on the outskirts of many major cities. With a heavy dose of irony, these communities were known as “Hoovervilles,” in honor of the then-president of the United States, Herbert Hoover. A contemporary observer described a Hooverville in New York City as follows:

It was a fairly popular “development” made up of a hundred or so dwellings, each the size of a dog house or chickencoop, often constructed with much ingenuity out of wooden boxes, metal cans, strips of cardboard or old tar paper. Here human beings lived on the margin of civilization by foraging for garbage, junk, and waste lumber. I found some . . . picking through heaps of rubbish they had gathered before their doorways or cooking over open fires or battered oilstoves. Still others spent their days improving their rent-free homes . . . Most of them, according to the police, lived by begging or trading in junk; when all else failed they ate at the soup kitchens or public canteens. . . . They lived in fear of being forcibly removed by the authorities, though the neighborhood people in many cases helped them and the police tolerated them for the time being.

SOURCE: © American Stock/Hulton Archive/Getty Images

SOURCE: Mathew Josephson, Infidel in the Temple (New York: Knopf, 1967), pp. 82–83.

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SOURCE: © Pictorial Press Ltd/Alamy

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The Great Depression was a worldwide event; no country was spared its ravages. It literally changed the histories of many nations. In Germany, it facilitated the ascendancy of Nazism. In the United States, it enabled Franklin Roosevelt to engineer one of the most dramatic political realignments in our history and to push through a host of political and economic reforms.

A Revolution in Economic Thought The worldwide depression also caused a much-needed revolution in economic thinking. Until the 1930s, the prevailing economic theory held that a capitalist economy occasionally misbehaved but had a natural tendency to cure recessions or inflations by itself. The roller coaster bounced around but did not run off the tracks. But the stubbornness of the Great Depression shook almost everyone’s faith in the ability of the economy to correct itself. In England, this questioning attitude led John Maynard Keynes, one of the world’s most renowned economists, to write The General Theory of Employment, Interest, and Money (1936). Probably the most important economics book of the twentieth century, it carried a message that was considered revolutionary at the time. Keynes rejected the idea that the economy naturally gravitated toward smooth growth and high levels of employment, asserting instead that if pessimism led businesses and consumers to curtail their spending, the economy might be condemned to years of stagnation.

In terms of our simple aggregate demand–aggregate supply framework, Keynes was suggesting that there were times when the aggregate demand curve shifted inward—as depicted in Figure 2 on page 87. As that figure showed, the consequence would be declining output and deflation. This doleful prognosis sounded all too realistic at the time. But Keynes closed his book on a hopeful note by showing how certain government actions—the things we now call monetary and fiscal policy—might prod the economy out of a depressed state. The lessons he taught the world then are among the lessons we will be learning in the rest of Part 2 and in Part 3—along with many qualifications that economists have learned since 1936. These lessons show how governments can manage their economies so that recessions will not turn into depressions and depressions will not last as long as the Great Depression, but they also show why this is not an easy task.

While Keynes was working on The General Theory, he wrote his friend John Maynard Keynes George Bernard Shaw that “I believe myself to be writing a book on economic

theory which will largely revolutionize . . . the way the world thinks about economic problems.” In many ways, he was right.

From World War II to 1973

The Great Depression finally ended when the United States mobilized for war in the early 1940s. As government spending rose to extraordinarily high levels, it gave aggregate demand a big boost. Thus, fiscal policy was (accidentally) being used in a big way. The economy boomed, and the unemployment rate fell as low as 1.2 percent during the war.

Figure 1(b) on page 86 suggested that spending spurts such as this one should lead to inflation. But much of the potential inflation during World War II was contained by price controls. With prices held below the levels at which quantity supplied equaled quantity demanded, shortages of consumer goods were common. Sugar, butter, gasoline, cloth, and a host of other goods were strictly rationed. When controls were lifted after the war, prices shot up.

A period of strong growth marred by several recessions after the war then gave way to the fabulous 1960s, a period of unprecedented—and noninflationary—growth that was credited to the success of the economic policies that Keynes had prescribed in the 1930s. For a while, it looked as if we could avoid both unemployment and inflation, as aggregate demand and aggregate supply expanded in approximate balance. But the optimistic verdicts proved premature on both counts.

The government’s fiscal policy is its plan for spending and taxation. It can be used to steer aggregate demand in the desired direction.

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Inflation came first, beginning about 1966. Its major cause, as it had been so many times in the past, was high levels of wartime spending. The Vietnam War pushed aggregate demand up too fast. Later, unemployment also rose when the economy ground to a halt in 1969. Despite a short and mild recession, inflation continued at 5 to 6 percent per year. Faced with persistent inflation, President Richard Nixon stunned the nation by instituting wage and price controls in 1971, the first time this tactic had ever been employed in peacetime. The controls program held inflation in check for a while. But inflation worsened dramatically in 1973, mainly because of an explosion in food prices caused by poor harvests around the world.

Stagflation is inflation that occurs while the economy is growing slowly (“stagnating”) or in a recession.

The Great Stagflation, 1973–1980

In 1973 things began to get much worse, not only for the United States but for all oilimporting nations. A war between Israel and the Arab nations precipitated a quadrupling of oil prices by the Organization of Petroleum Exporting Countries (OPEC). At the same time, continued poor harvests in many parts of the globe pushed world food prices higher. Prices of other raw materials also skyrocketed. By unhappy coincidence, these events came just as the Nixon administration was lifting wage and price controls. Just as had happened after World War II, the elimination of controls led to a temporary acceleration of inflation as prices that had been held artificially low were allowed to rise. For all these reasons, the inflation rate in the United States soared above 12 percent during 1974.

Meanwhile, the U.S. economy was slipping into what was, up to then, its longest and most severe recession since the 1930s. Real GDP fell between late 1973 and early 1975, and the unemployment rate rose to nearly 9 percent. With both inflation and unemployment unusually virulent in 1974 and 1975, the press coined a new term—stagflation—to refer to the simultaneous occurrence of economic stagnation and rapid inflation. Conceptually, what was happening in this episode is that the economy’s aggregate supply curve, which normally moves outward from one year to the next, shifted inward instead. When this happens, the economy moves from a point like E to a point like A in Figure 7. Real GDP declines as the price level rises.

Thanks to a combination of government actions and natural economic forces, the economy recovered. Unfortunately, stagflation came roaring back in 1979 when the price of oil soared again. This time, inflation hit the astonishing rate of 16 percent in the first half of 1980, and the economy sagged.

FIGURE 7

The Effects of an

Adverse Supply Shift

		S1
		D
		S0
	Level	A
		E
	Price
	S1	D
		S0

Real GDP

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