n the early 1980s the United States endured one of the worst economic downturns the nation faced

since the great depression. Economists often focus on two main causes of the recessions, (1) the oil crisis of

1979

which

dramatically

increased

energy

prices

and (2) the macroeconomic policy decisions made

throughout the 1960s and 70s. During this time period many economists believed that there was a trade-off

between inflation and unemployment, as depicted by the Phillips curve. While the data and policy outcomes

initially appeared to support this idea, by the late 1970s when the economy experienced higher inflation and

higher unemployment simultaneously, it was clear that this tradeoff ceased to exist in the long run.

Paul Volcker became Chairman of the Federal Reserve in August 1979. In contrast with previous Fed

policies that vacillated between focusing on inflation and unemployment, his main priority was to get inflation

under control. To achieve the desired disinflation, Volcker implemented contractionary monetary policies that

led to a sharp increase in interest rates. As a result, inflation decreased dramatically, from about 13% in

1980 to less than 3% in 1983. However, these contractionary policies came at a sharp short-run cost as the

unemployment rate surged from 7% to about 10% over the same period. Volcker argued that once the public

believed that the Fed was no longer going to tolerate inflation that inflationary expectations would quickly

decrease, allowing the economy to swiftly recover and unemployment to fall. The data seem to support

Volcker's policies, as the early 1980s experienced a painful recession but then a quick recovery followed,

and in the decades since inflation hasn't come close to returning to 1970s levels and unemployment has

mostly remained low. Use data above to draw the Phillips curve in 1980 with the

economy facing stagflation. Label this point "A".

12. Show the short-run results of Chairman Volcker's

leadership on the Phillips curve. Label this point of

short-run equilibrium point "B", and indicate new inflation

and unemployment rates using data from the article.

13. Show the long-run results of the contractionary policy once

inflationary expectations adjust to a new lower rate of

inflation. Label this point "C".