Tight Money, 1979-1982.
By 1979 the economy had recovered from the 1973 supply shock. Output had returned to its potential. But unrest in the Middle East led to another oil shock as the Iranian revolution produced a jump in oil prices from $14 per barrel in early 1978 to $34 per barrel in 1979. Inflation increased dramatically-averaging 12 percent per year from 1978 to 1980.
We can picture how tight money raised interest rates and reduced aggregate demand in Figure 20-7 simply by reversing the arrow.’ That is, tight monetary policy reduced spending and produced a leftward and downward shift of the aggregate demand . curve-exactly the opposite of the effect of the defense buildup during the 1960s. The decrease in aggregate demand reduced output almost 10 percent below its potential by the end of 1982, and the unemployment rate rose from below 6 percent in 1979 to more than 10 percent at the end of 1982.
The tough monetary. policies of the 1980s set the stage for the .long economic expansion from 1982 through 2000. This period marked by a single mild recession in 1990-1991, proved to be the period of the greatest macroeconomic stability in American history. Real GDP grew at an average rate of 3 percent annually, with price inflation averaging slightly above percent. By the late 19905, many of those in the workforce had never experienced a severe business cycle or inflationary episode, and some were proclaiming naively that
the business cycle was abolished in this “new era” economy.
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