Case Study 1 — The 1970s Stagflation: When the Phillips Curve Broke
In the 1960s, mainstream macroeconomics taught that policymakers faced a stable trade-off: lower unemployment meant higher inflation, and vice versa. The Phillips curve was the centerpiece of policy analysis. Policymakers chose their preferred point on the curve — say, 4% unemployment and 3% inflation — and used monetary and fiscal policy to get there.
The 1970s destroyed this worldview. Two OPEC oil embargoes (1973, 1979), combined with loose monetary policy (under Fed Chairs Burns and Miller), produced something the Phillips curve said shouldn't exist: stagflation — high inflation AND high unemployment simultaneously. By 1980, inflation was 13.5% and unemployment was 7.1%.
What happened
1973 oil shock: OPEC imposed an embargo in response to U.S. support for Israel during the Yom Kippur War. Oil prices quadrupled from $3 to $12/barrel. Every product that used energy in its production (which is nearly everything) became more expensive. This was cost-push inflation on a massive scale.
The Fed's mistake: rather than accepting some temporary unemployment to prevent the supply shock from becoming entrenched in expectations, the Fed kept monetary policy loose. Chairman Arthur Burns argued that oil-driven inflation was "special" and shouldn't be fought with rate hikes (which would cause a recession). The result: inflation expectations became unanchored. Workers demanded higher wages to keep up with rising prices. Firms passed the wage increases through as higher prices. A wage-price spiral developed.
1979 oil shock: Iran's revolution disrupted oil supply. Prices doubled again. Inflation, already high, accelerated further.
By 1980: inflation was 13.5%, unemployment was rising toward 8%, and the Phillips curve was useless as a policy guide. The trade-off had disappeared — or rather, it had been overwhelmed by the shift in expectations.
What the episode proved
Friedman and Phelps were right. Their 1967–68 prediction — that the Phillips curve trade-off was temporary and would disappear once expectations adjusted — was confirmed by the 1970s. The short-run curve shifted upward as expectations rose. What looked like a stable trade-off was actually a moving target.
Expectations matter more than shocks. The oil shocks were real, but they were temporary. If expectations had remained anchored, the inflationary impact would have been brief (as Volcker later demonstrated — the 2022–23 disinflation achieved similar results from a supply-affected starting point because expectations were anchored). The 1970s inflation became entrenched because the Fed failed to anchor expectations.
Credibility is the central bank's most important asset. The 1970s were the decade when the Fed's credibility was lowest. The 2020s were the decade when it was highest (thanks to Volcker). The difference in outcomes was dramatic.
Discussion questions
- Was it a mistake for the Fed to keep rates low after the 1973 oil shock? What would have happened if it had raised rates aggressively?
- Friedman and Phelps predicted the breakdown of the Phillips curve in 1967–68. Why didn't policymakers listen?
- Compare the 1970s to the 2020s: both had supply shocks (oil/supply chains), both had monetary policy debates. Why were the outcomes so different?
- "Stagflation proved that Keynesian economics was wrong." Is this too strong a claim?