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INFLATION AND UNEMPLOYMENT
The extremely unbalanced nature of the inflation, particularly in its early stages, supports the conclusion that the inflation was due primarily to a few special factors. Inflation caused by excess economic activity tends to proceed in a much more balanced way across the whole range of goods and services. While the existence of price controls may have distorted normal relationships, there simply was no serious inflation in 1973 except in those sectors which had special problems.
Further evidence that the inflation was not due to excess aggregate demand is found in the relation between inflation and the level of utilization of capacity of the economy.
The following chart presents the history of inflation and unemployment since 1954. Note that until 1973, the unemployment rate and the inflation rate generally moved in opposite directions. Over that period,
12 month moving average of CPI.
12 month moving average of the unemployment rate,
one could make reasonably good predictions of how the inflation rate would change simply by noting the unemployment rate. When the unemployment rate was below the 4.5 to 5 percent range, inflation accelerated; when it was above that range, inflation fell.
This data supports the conclusion that in the 2 decades before late 1973, inflation was caused by excess demand. When the economy expanded, the unemployment rate fell and the inflation rate increased. Since late 1973, a different relationship has emerged. Inflation appeared when the unemployment rate was not excessively low, and it continued to accelerate even when unemployment was quite high. Instead of excess purchasing power driving prices up, in the recent period the higher prices have reduced real purchasing power and forced cutbacks in production.
The price controls of 1973–74 offer an alternative explanation of the unbalanced nature of the inflation, since it was worst in those sectors which were uncontrolled. But if the inflation had been due to excess demand, one would have expected the unemployment rate to fall when the inflation rate increased. The fact that since mid-1973 they both increased at the same time supports the conclusion that the increased rate of inflation since that time has been due to cost factors rather than to demand.
SUMMARY TO APPENDIX Just as these higher prices caused production to fall, lower prices brought about by direct government action can cause production to increase. While there remains a tradeoff between inflation and unemployment, in the sense that general economic activity affects them in opposite directions, policies are available which can reduce both of these evils at the same time.
The unbalanced nature of the recent inflation suggests that it was caused by special cost factors rather than by excess demand. This conclusion is also supported by the fact that this inflation was accompanied by high rather than low unemployment rates. Since reduction in those prices that are directly controlled by government should have the opposite effect on the economy to that caused by the OPEC price increase, it should be expected that prices and unemployment can be reduced at the same time through a policy of direct reductions in costs.