Stagflation of the 1970s: Why High Inflation and Unemployment Came Together

Stagflation is the combination of stagnant economic output, high unemployment and high inflation at the same time. Before the 1970s, economists broadly expected inflation and unemployment to move in opposite directions, so a period with both rising together was a surprise. The decade in the United States and other advanced economies showed that this pattern was possible, and it forced a rethinking of macroeconomic policy.

This post explains the economic background, the oil shocks that acted as triggers, the policy choices that let inflation become entrenched, and how the episode was finally brought under control.

The old trade-off

The Phillips curve, named after economist A. W. Phillips, described an inverse relationship between unemployment and wage or price inflation in data from the United Kingdom in the late 1950s. In the decades after the Second World War, many policymakers treated this relationship as a menu. A government could accept somewhat higher inflation in exchange for lower unemployment, or the reverse.

Economists began to challenge this view in the late 1960s. Milton Friedman and Edmund Phelps argued that the trade-off only held in the short run, because workers and firms adjust their expectations of inflation over time. If the central bank keeps pushing unemployment below its natural level, inflation expectations rise and the trade-off disappears. The 1970s provided evidence in favour of this argument.

Background: the end of fixed exchange rates

The Bretton Woods system, agreed in 1944, pegged major currencies to the US dollar, which was convertible into gold at a fixed price. In August 1971 the United States suspended the convertibility of dollars into gold. The move ended the system of fixed exchange rates and left currencies to float, at least partly, in the following years.

Between 1971 and 1974 the US government also used wage and price controls in an attempt to limit inflation. Controls suppressed visible price rises for a time, but they did not address the underlying growth in money and spending. When controls were lifted, prices adjusted upward, and some shortages and distortions remained.

The oil shocks

Two large supply shocks gave the decade its defining character. In October 1973 members of the Organization of the Petroleum Exporting Countries (OPEC) imposed an oil embargo on countries that had supported Israel in the Yom Kippur War. Oil prices rose sharply, and by early 1974 the price of crude had roughly quadrupled from its level a year earlier.

A second shock followed in 1979, when the Iranian Revolution disrupted supply and panic buying pushed prices up again. Oil prices roughly doubled over the following months. Oil is an input to nearly every sector, so the shocks raised production costs widely, which tends to reduce output and employment while pushing up prices.

The table below lists approximate headline figures for the United States. Values are rounded and drawn from widely reported series, and they vary somewhat with the source and measurement method.

Indicator	Approximate peak or level	Period
Annual CPI inflation	About 14.8 percent	Early 1980
Unemployment rate	About 10.8 percent	Late 1982
Federal funds rate	About 19 to 20 percent	Mid 1981
Crude oil price rise	Roughly fourfold	1973 to 1974

Why supply shocks are hard to fix

A demand shock, such as a sudden rise in spending, tends to raise output and prices together. A supply shock raises prices while lowering output, because the economy produces less at each price level. Policymakers face a difficult choice. Expanding demand to restore output adds to inflation. Restricting demand to fight inflation deepens unemployment.

When inflation expectations are already high, the problem worsens. Workers demand higher wages to keep up with prices, firms raise prices to cover higher wages and energy costs, and the cycle feeds on itself. This wage-price spiral became a central concern of 1970s policy debates.

Policy mistakes and accommodation

Many economists argue that monetary policy in the early and mid 1970s accommodated the shocks rather than resisting them. Central banks allowed money growth to rise to avoid recession, which kept nominal spending high and allowed prices to keep climbing. The Federal Reserve under Arthur Burns in the early 1970s was often criticised for this approach, although historians debate how much of the blame belongs to the central bank and how much to fiscal policy, wage controls and external shocks.

Inflation expectations became unanchored. Once businesses and households expected high inflation to persist, it became harder to bring down. Each episode of tightening was followed by pressure to loosen policy when unemployment rose, which suggested to markets that the commitment to price stability was limited.

The Volcker disinflation

Paul Volcker became chairman of the Federal Reserve in August 1979. He tightened monetary policy sharply, targeting growth in the money supply and allowing short-term interest rates to rise to very high levels. The federal funds rate reached roughly 19 to 20 percent in 1981.

The policy caused a deep recession in 1981 and 1982, with unemployment reaching about 10.8 percent at its peak in late 1982. Inflation fell substantially over the following years, and by the mid 1980s it had returned to much lower levels. The cost was high, and it fell hardest on workers in manufacturing and on borrowers facing high interest rates.

The episode is widely regarded as establishing the credibility of the Federal Reserve as an inflation fighter. Once expectations adjusted, later periods of economic growth proceeded with lower and more stable inflation.

Comparisons with other countries

The stagflation pattern was not limited to the United States. Many advanced economies experienced high inflation and slow growth during the decade, and the oil shocks affected energy importers across Europe and Asia. Countries differed in how they responded. Some used wage agreements, some used tighter fiscal policy, and some allowed currencies to depreciate. The outcomes varied, but the common lesson was that inflation, once entrenched, is costly to remove.

Lessons for economists and policymakers

The 1970s changed how economists think about inflation. Expectations are now treated as a central part of inflation dynamics, and the idea of a stable long-run trade-off between inflation and unemployment has been largely abandoned. Central banks in many countries adopted explicit inflation targets to anchor expectations, and they became more willing to tolerate short-term output losses to prevent prices from rising persistently.

Supply shocks remain a challenge. Energy prices, trade disruptions and other supply events can still produce inflation with weak growth. The 1970s show that the best response depends on how firmly expectations are anchored and how quickly policy can credibly respond.

Key takeaways

Stagflation combined high inflation, high unemployment and weak growth. It defied the older view of a stable Phillips curve trade-off and forced economists to incorporate inflation expectations into their models.

The oil shocks of 1973 to 1974 and 1979 raised costs across the economy. Monetary accommodation, wage-price feedback and the loss of an anchor for expectations allowed inflation to persist.

The Volcker disinflation of the early 1980s brought inflation down at the cost of a deep recession. It established that credible commitment to price stability is essential, and that a central bank must be willing to accept short-term pain to restore it.