[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

is eliminated and the economy is back at full employment, there is no further downward
pressure on inflation. Eventually the economy reaches a new long-run
equilibrium at full employment at the point E 2 , with an inflation rate of π 1 .
Case in Point
THE VOLCKER DISINFLATION
In 1979 and 1980, there was widespread agreement that something should be done
to halt inflation. At the time, inflation was at a postwar high and appeared to be
moving even higher. The economy was at a point such as E 0 in Figure 31.5—it was
at full employment (the unemployment rate was 5.8 percent in 1979, about equal to
estimates of full employment at the time), but the inflation rate was very high (over
8 percent in 1979 as measured by the GDP price deflator).
Paul Volcker, then the chair of the Federal Reserve Board, pushed through a
sharp increase in interest rates in order to choke off inflation. This action represented
a major shift in the monetary policy rule. As a result of the higher real interest
rates, firms cut back their investments, and households cut back their purchases
of items such as new cars and homes. Interestingly, at the same time that the Fed was
taking actions to restrict aggregate spending, fiscal policy was stimulating the economy.
President Reagan cut taxes without cutting government expenditures by an
PERCENT
12
10
8
6
4
2
0
–2
–4
–6
–8
Inflation
(left axis)
Output gap
(left axis)
Unemployment rate
(right axis)
–10
0
1979 1980 1981 1982 1983 1984 1985 1986
12
10
8
6
4
2
PERCENT
Figure 31.6
THE OUTPUT GAP,
UNEMPLOYMENT RATE, AND
INFLATION RATE IN THE 1980s
In the late 1970s and early 1980s, the Federal Reserve Board, worried about runaway inflation,
acted to restrict credit and thus consumption and investment. The decrease in aggregate
demand raised unemployment and lowered output below potential. The effects more
than offset the expansionary effects of the 1981 tax cut. Inflation gradually declined, and
by 1985, the economy was back at full employment, with a lower rate of inflation.
SOURCES: Unemployment, Economic Report of the President (2001), Table B-35; inflation, Economic
Report of the President (2001), Table B-64; output gap, Federal Reserve Board.
700 ∂ CHAPTER 31 AGGREGATE DEMAND AND INFLATION