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. He remained Chairman of the Federal Reserve Bank until 1987.

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. Oil shocks and inflation were not the only problems within the the decade. While supply shocks raised the price level it can not explain persistent periods of inflation. In addition, the increase in inflation was experienced by the United States before the oil crisis emerged in the 1973. While Johnson, president during the late 1960's before President Nixon, had instituted policy where unemployment fell by two percent, the more important figure of this policy was inflation only rose by three percent. This is expected when you look at a Phillips Curve where unemployment and inflation are inversely related. File:P-c.jpg

 The problem during the 1970's was the country experienced stagflation where both unemployment and inflation rose at the same time.

Disinflation Effort

Aside from the Great Depression, the change in inflation that occurred during the early part of the 1980s represents the most important macroeconomic event of the 20th century. Using long-term interest rates as the key indicator of inflationary expectations, Volcker was able to successfully combat the high inflation. In 1979 at the onset of his term at the FED, Volcker faced an annual average inflation rate of 9%. The inflation rate peaked in early 1980 at 11%. During Volcker tenure, the economy of the United States experienced the largest business cycle declines since WWII, as the unemployment rate rose considerably and ouput fell.

Inflation Slayed

With the inflationary dragon finally slayed, in 1982 the Fed returned to a policy of smoothing out interest rates. 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 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. As shown here:

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The most important impact of Volcker's actions was not saving the country from high levels of inflation or wringing out the inflationary expectations that workers had. Volcker was the first chairman of the Fed to thoroughly implement Milton Friedman's theories. Volcker shifted the Fed's primary priority from controlling unemployment and keeping it to a minimum to price stability and controlling inflation. The adverse short run effects of what Volcker did was unemployment went way up. However, in the long run, as the economy was expanding, unemployment gradually fell. As the economy continued to expand, inflation stayed under 3% almost every year for the next 25 years. Greenspan and Bernake continued this process by reducing inflation even more, and by removing inflationary expectations from the economy.