SECTION8
Sometimes it’s not easy being at the helm of the Federal Reserve—
When the U.S. economy went into a recession in 2001, the Fed, under the leadership of then chairman Alan Greenspan, rushed cash into the system. It was an easy choice: unemployment was rising, and inflation was low and falling. In fact, for much of 2002 the Fed was actually worried about the possibility of deflation.
For much of 2008, however, the Fed chairman at the time, Ben Bernanke, faced a much more difficult problem. In fact, he faced the problem people in his position dread most: a combination of unacceptably high inflation and rising unemployment, often referred to as stagflation. Stagflation was the scourge of the 1970s: the two deep recessions of 1973–
Why did the economic difficulties of early 2008 look so different from those of 2001? Because they had a different cause. The lesson of stagflation in the 1970s was that recessions can have different causes and that the appropriate policy response depends on the cause.
Many recessions, from the great slump of 1929–
The recessions of the 1970s, however, were largely caused by events in the Middle East that led to sharp cuts in world oil production and soaring prices for oil and other fuels. Not coincidentally, soaring oil prices also contributed to the economic difficulties of early 2008. In both periods, high energy prices led to a combination of unemployment and high inflation. They also created a dilemma: should the Fed fight the slump by pumping cash into the economy, or should it fight inflation by pulling cash out of the economy?
It’s worth noting, by the way, that in 2011 the Fed faced some of the same problems it faced in 2008, as rising oil and food prices led to rising inflation despite high unemployment. In 2011, however, the Fed was fairly sure that demand was the main problem.
In the previous section we developed the income–
In this section, we’ll develop a model that shows us how to distinguish between different types of short-
To develop this model, we’ll proceed in three steps.