Paul Volcker Slays the Inflationary Dragon

The Slayer's Past

Paul Volcker was born in Cape May, New Jersey in 1927. He received his undergraduate studies at Princeton University and later attended Harvard University and the London School of Economics for his graduate studies. His career started in 1952 with the Federal Reserve Bank of New York. He left after five years where he became a financial economist at Chase Manhattan Bank. He spent five years with Chase Manhattan Bank and later returned to become the vice-president and director of planning. During his hiatus from Chase Manhattan Bank he worked as the director of financial analysis for the U.S. Tresury Department. He also worked with the head of the Treasury for four years until 1979, when he became the chairman of the Fed.

Pre 1979 Economic Conditions

Before Volcker became head of the Fed in 1979 the economy was experiencing a period of decline. Between high inflation and oil shocks the Federal Reserve needed to take an active role in slowing expected inflation. Because inflation did not seem to be targeted by the Fed pre-Volcker the country experienced systematic increases in inflation from year to year. The inflation was highly volatile and the country was experiencing recessions partly due to the Fed's highly accomodative attitude which let short-term interest decline while anticipated inflation rose. To try and combat these situations the Fed tried to raise nominal rates the attempts failed because the amount that the nominal rates were raised was by less than the increase in expected inflation. The oil crisis of 1973-74 generated monetary accomodation in the short run which helped keep the economy from experiencing a period of output-growth reducing period. The response to this exogenous shock can not hold up in the medium or long run which will result in a slowing of output-growth.

Inflation Slayed

With the inflationary dragon finally slayed, in 1982 the Fed returned to a policy of smoothing out interest rate. It did this by placing less emphasis on monetary aggregate targets and shifting to borrowed reserve targets as a monetary tool. A borrowed reserve target smoothes interest rate because because as output rises, interest rates will also rise. This causes bank to borrow more money from the Fed and therefore the amount of borrowed reserves will increase. In an effort to prevent the level of borrowed reserves from exceeding its target, the Fed will lower interest rates through open market purchases to increase the price of bonds. The result of using a borrowed reserve target is that the Fed is able to prevent a rise in interest rates. Although, by using this tool, the open market purchases by the Fed will increase the monetary base, which will then lead to an increase in the money supply.