An Effective Demand look at the inflation of the 1970’s

Some posts lately about the inflation of the 1970’s… Steve Randy Waldman, Steve Roth, Scott Sumner and me. Here is a graph of the inflation during the 1970’s…

Link to graph #1.

We see that there are 2 spikes of inflation that happened during the two recessions that formed during the 1970’s. Did monetary policy cause these recessions as Scott Sumner says? Did the growth of the labor force from the maturing baby-boomers cause the inflation as Steve Randy Waldman lays out? Or was it something else? Maybe the LRAS curve?

Theory states that at the LRAS curve (long-run aggregate supply) is vertical because it is an area signalling potential output of the economy. And since the economy cannot produce much more than its potential, increases in aggregate demand at the LRAS curve result in increases in the price level and not real growth of output.

I am going to take a standard look at these recessions from the perspective of my effective demand research to see if there is evidence of the LRAS curve causing increases in the price level.

The effective demand limit is another way to define potential output of the economy. It is the limit upon output from labor’s share of national income, which determines labor’s limit to purchase output, irregardless of whether the economy could produce more even if all prices and nominal wages were fully flexible. The effective demand limit is reached when real GDP is equal to effective demand.

Let me start by showing a graph using the Aggregate supply-Effective demand (AS-ED) model for the recession that started in the 4th quarter of 1973.

Link to graph #2.

First start by locating at real GDP which comes in from the left (green dots) tracking along an inflation rate around 3%. We see that rate in graph #1 for 1972 and part of 1973. The horizontal dashed black line shows the track of real GDP. Then we see the diagonal dashed black line coming down from the left. This diagonal line is effective demand tracking directly into a meeting place with real GDP at around $5300 billion (2009 dollars). Effective demand tracks in very strong before this recession. The thick purple line is actually 4 lines of data all tracking in at the exact same place. That is 4 quarters of exactly the same effective demand.

Look at the two yellow dots. The first yellow dot is the crossing point of real GDP and effective demand at the 4th quarter of 1972. Real GDP (last green dot) had not yet reached the effective demand limit. However, the second yellow dot below corresponds to the first red dot of real GDP. We see here that real GDP had passed the effective demand limit and thus entered into the zone of the LRAS curve.

And what happens in the LRAS zone? Output slows down… and increases in aggregate demand result in increases in the price level. This is exactly what happened. We see the real GDP going vertical with increasing inflation.

So I would not attribute the inflation to either the demographics of the baby-boomer influx or to loose monetary policy. The inflation was simply the dynamic of the economy reaching the potential output as determined by the effective demand limit.

So what happened in the recession of 1980? Well, I have already posted this explanation. Here is the graph from that post…

Link to graph #3.

The same thing happened here. Inflation was the result of real GDP reaching potential output as determined by the effective demand limit. As real GDP entered the LRAS zone, output slowed down and inflation began to rise. Inflation rose differently in each recession. Real GDP kept growing some in this 1980 recession, but real GDP stopped in its tracks when it hit the LRAS zone in 1973.

So I see the inflation of the 1970’s as mostly a product of real GDP hitting the LRAS zone as determined by the effective demand limit.

I like what Steve Randy Waldman has to say about the baby-boomers entering the labor force. They were a force behind pushing real wages higher. But I want to use an equation to clarify what happened.

Productivity = real hourly compensation/labor share

I graph all three variables in this graph…

Link to graph #4.

Productivity (blue line) was rising in between recessions. Real compensation per hour (red line) was rising too. But labor share of income (green line) was either falling or steady. Labor was making more money per hour, but owners of capital were taking a little bigger share of the income produced. Still with the increase in the labor force, there were more dollars chasing goods and services to keep inflation boosted… especially after the 1973 recession, when labor maintained its share and received higher real hourly compensation.

As far as monetary policy causing inflation, I don’t see it. The actual Fed rate was trying to push inflation down to a 3% inflation target. It is not the Fed’s doing that inflation rose above that. There were other factors like Steve Randy Waldman’s insight into the baby-boomers coming of age.