Central bankers often believe that their hands are tied by the public. Arthur Burns, the Fed chairman under President Nixon, reportedly said in the November 1970 Federal Reserve board meeting that “he did not believe the country was willing to accept for any long period an unemployment rate in the area of 6%.” In other words, if AD shocks or potential growth shocks came along that pushed the unemployment rate up, Burns believed he had to boost AD to help the economy: The voters wouldn’t tolerate anything else.
a. In the early 1970s, the economy was hit with some negative potential growth shocks, the most famous of which were the massive oil price increases caused by the OPEC oil embargo. Inflation started off at 4%, and Burns actually behaved according to his stated philosophy. What did Burns do to AD in the 1970s: Did he raise it or lower it?
b. If Burns had kept AD fixed instead of shifting it as he did, would inflation have been lower or higher than it actually turned out to be?
c. According to our model, did Burns’ actions raise, lower, or have no impact on the long-run aggregate supply curve?
d. If in the 1970s the United States had been hit by negative AD shocks instead of negative potential growth shocks, and Burns had followed his same philosophy, would inflation have been higher or lower than it actually turned out to be?