Double digit inflation

Question

During the year 1980 period, what did the FED Chairman Paul Volcker do to decrease double digit inflation of 1970’s? What was the name of the person and or the economic school’s approach which Volcker employed?

Answer 1

Inflation increased from 2.6% in mid-1960s to 5% in late 1960s and early 1970s, later to 8% in the period of 1974 to 1978 and reached a high of 13.5% in 1981. Paul Volcker targeted the federal funds rate to attack the double digit inflation of the 1970’s. The Federal Funds rate refers to the interest rate at which banks trade balances held with the Fed. By increasing the federal funds rate gradually, Volcker decreased the money supply to such an extent that businesses had to cut down their expenses and reduce their labor because they could not afford to pay their wages.

Though there was a short recovery in 1981, Volcker still decreased the money supply by increasing the rate to 20%, which led to the worst recession after the Great Depression. Unemployment rate surged up to 10% but even then Volcker did not ease the supply. Inflation slowly dropped to 5% in the fall of 1982. Volcker reduced the fed funds rate to 9% in such a period. Though the recession ceased in late 1982, the rate was not yet decreased to lower than 8%. Thus Volcker used a contractionary monetary policy though the US economy led to a double-dip recession.

Volcker thus employed an intentional recession to lower the double digit inflation. This approach can be termed partially Keynesian approach as well as monetarism approach. Milton Friedman was the creator of monetarist theory, and Volcker employed the Friedman rule by increasing the Fed funds rate and contracting the economy. Later, Volcker reverts to Keynesian policies while expanding the economy by lowering the fed funds rate after the inflation has come under control. So it can be considered that Volcker used Friedman rule to combat inflation.