Breaking the Curve: How 1970s Stagflation Rewrote the Rules of Economics

Introduction

The 1970s were a decade of upheaval—not just socially and politically, but economically as well. The global economy was rocked by a phenomenon that economists of the time believed to be impossible: stagflation. For years, prevailing economic theories insisted that inflation and unemployment had an inverse relationship—a tradeoff neatly illustrated by the Phillips Curve. Yet the 1970s delivered a rude awakening: surging inflation and rising unemployment occurring simultaneously.

This period of economic chaos it shattered the intellectual foundation of mainstream economics and ushered in a new era of thought incorporating Monetarist ideas. The failure of traditional tools to address this paradox forced economists to reconsider their understanding of inflation, unemployment, and monetary policy. At the center of this revolution stood figures like Milton Friedman, whose theories of inflation expectations and the natural rate of unemployment not only explained stagflation but also provided the roadmap for resolving it.

In this article, we’ll explore how the standard economic thinking leading up to and during the 1970s contributed to the crisis, how stagflation exposed the flaws in standard economic thinking, and how it ultimately reshaped economic policy for decades to come. 

The story begins with an outdated economic model: the Phillips Curve. First proposed by economist A. W. Phillips in the 1950s, the Phillips Curve was an economic model that suggested an inverse relationship between inflation and unemployment. Policymakers, including the Federal Reserve, relied heavily on this framework, believing they could trade higher inflation for lower unemployment. At the time, the Federal Open Market Committee prioritized reducing unemployment, earning the moniker “unemployment doves.” They viewed inflation as a tolerable side effect in the pursuit of higher employment. This belief drove the Federal Reserve’s expansionary monetary policies throughout the 1960s, which included lowering interest rates, reducing reserve requirements, and engaging in open market operations (Figure 1). As a result, all through the 1960s, unemployment stayed low as the economy looked up.  

Figure 1: Low interest rates during the 1960s, preceding the stagflation period.

However, by the 1970s, the flaws in this approach became glaringly apparent. As shown in Figure 2, by 1973, inflation and unemployment surged together, breaking down the Phillips Curve's presumed tradeoff. Economists of the day struggled to explain this phenomenon, with some attributing it to external shocks like the OPEC oil embargo. The embargo, which followed President Nixon’s decision to abandon the gold standard, quadrupled oil prices, leading to cost-push inflation and weakened demand in labor markets. While this undoubtedly contributed to economic instability, other nations heavily reliant on OPEC oil, such as Germany and Switzerland, experienced far milder inflation. Clearly, this was not the primary cause: There were deeper systemic issues in the U.S. economy.

Figure 2: Rising inflation and unemployment during the mid-1970s and early 1980s.

Friedman Enters the Scene

As mainstream economists faltered, Milton Friedman, a future Nobel laureate and leading figure of the Monetarist School at the University of Chicago, provided a groundbreaking explanation. Friedman argued that stagflation was not an anomaly but the predictable result of flawed monetary policies, asserting that “inflation is always and everywhere a monetary phenomenon”. This was a direct challenge against the Phillips Curve and, for the first time in decades, a direct challenge against the economic orthodoxy. 

Friedman introduced the concept of the Natural Rate of Unemployment, positing that attempts to reduce unemployment below its natural level through monetary or fiscal policy would only accelerate inflation. Structural changes in the labor market during the 1970s had increased Natural Rate of Unemployment (Figures 3 and 4), rendering the Phillips Curve unreliable at higher levels of unemployment. Friedman explained that expansionary policies aimed at reducing unemployment merely heightened inflation expectations, leading to rising nominal wages and a vicious wage-price spiral.

Figure 3: The rise in the Natural Rate of Unemployment during the 1970s, correlating with higher unemployment.

Figure 4: Structural unemployment increased in the 1970s

When the Federal Reserve pushed unemployment down through inflationary policies, they temporarily succeeded, but inflation expectations caught up, driving wages higher (Figure 5). This, in turn, caused cost-push inflation without a sustained reduction in unemployment, shifting the Phillips Curve upward and exposing the limitations of the model.

Figure 5: Rising nominal wage growth in the 1970s, followed by stabilization during the "Great Moderation."

These higher nominal wages and labor costs gave rise to cost-push inflation and even an even higher inflation level than those initially caused by the rise in Aggregate Demand. However, this rise in the inflation level, being driven by Rational Expectations and nor Aggregate Demand, does not lower the unemployment level. As the inflation level grew, expectations once more pushed up labor costs, causing the Wage-Price Spiral. The Wage-Price Spiral. The wage-price spiral is a self-reinforcing cycle where rising wages lead to higher production costs, prompting businesses to raise prices. In turn, higher prices to demand even higher wages to keep up with the cost of living. This cycle repeats, fueling inflation as wages and prices continuously push each other upward. This case of a higher inflation level but an unchanged unemployment level gave rise to an upwards shift of the Phillips Curve, as is evidenced in Figure 6.

Figure 6

The results of this was disastroues

The Volcker Shock

This period of simultaneous high inflation and high unemployment only ended in the 1980s when Chairman Paul Volcker, a Monetarist, followed Milton Friedman’s suggestions and raised interest rates to nearly 20% (Figure 1), bringing down the money supply killing Inflation Expectations. Although this brought high unemployment and a separate recession of its own, it is credited for ultimately bringing an end to the Stagflation. Volcker’s successor,  Alan Greenspan, further solidified the Monetarist legacy, maintaining a focus on inflation control and ushering in a period of economic stability and low inflation known as the "Great Moderation" (Figure 7).

Figure 7: A history of U.S. inflation, highlighting the key role of monetary policy in major inflationary periods.

Legacy of the 1970s Stagflation

The stagflation of the 1970s marked a turning point in economic thought, catapulting Milton Friedman and the Monetarist School to prominence. Friedman’s insights into the Natural Rate of Unemployment and inflation expectations reshaped central banking and challenged the Keynesian dominance that had prevailed since the Great Depression. His ideas remain foundational, influencing how policymakers approach inflation and unemployment to this day. By exposing the limits of Keynesianism and validating the principles of Monetarism, the 1970s crisis secured Friedman’s place alongside Keynes as one of the most influential economists of the 20th century.

In the end, the story of stagflation lies not only in the lessons it taught about economic policy but also in the transformative power of economics. This is the prime example of how economic tools, misused horribly, can destroy the livelihoods of millions of households America. On the other hand, soundly verified economic insights, wielded well, can lift Americans out of poverty and drastically improve quality of life around the country. For every father, struggling to find a job, or mom, struggling to afford groceries, the disconnected, ivory tower economists in Washington hold inordinate control over their lives. Whether we use this economic power for good or ill is up to our new generation of economists. The future of countless lives depends on it.