Promoting Economic Stability
The three main types of economic instability are unemployment, sluggish or negative economic growth, and inflation. Over time the government has increased its role in promoting economic stability. Today the government's main stabilization policies are monetary policy, which is formed by the Federal Reserve System, and fiscal policy, which is determined mainly by Congress. There are limitations to these stabilization policies. Since the Great Depression of the 1930s, a number of different approaches to economic stabilization have been implemented with varying degrees of success.
Laissez-faire capitalism dominated the U.S. economic landscape for much the nineteenth and early twentieth centuries. Under laissez-faire capitalism America shunned most types of government intervention in economic activity, including interventions to stabilize prices in the economy. The severity of the Great Depression of the 1930s and the sacrifices necessary to mobilize the nation during World War II (1941–1945) irrevocably altered people's perceptions of “limited government,” however. Immediately after World War II, Congress passed the Employment Act of 1946. This historic act helped define economic stability by making “maximum employment, production, and purchasing power” central economic goals of the U.S. economy. Protecting the purchasing power of the U.S. dollar is directly linked to price stability, namely, preventing inflation and deflation in the economy.
Types of Inflation
Inflation is an increase in the overall price level for goods and services in an economy. The two main types of inflation are demand-pull and cost-push inflation. Demand-pull inflation occurs when excess demand in the economy causes people to bid up the prices of products. That is, aggregate (total) demand is greater than the aggregate (total) supply in the overall economy. Economists often describe demand-pull inflation as “too much money chasing too few goods.”
The main culprit for most demand-pull inflation is irresponsible government policies that flood the economy with paper currency. When the government injects too much money into an economy, the currency loses value. This forces producers to increase the prices of many products. In extreme cases the resulting inflation races out of control, a situation called hyperinflation. Hyperinflation renders a currency virtually worthless, as was the case in post–World War I Germany. More recently hyperinflation in Zimbabwe during the early 2000s caused this nation to formally abandon its currency in 2009. Since 2009 business activity in Zimbabwe has been conducted in foreign currencies, including the U.S. dollar.
Cost-push inflation occurs when the costs of production increase, forcing businesses to increase the price of their output. The costs of production are payments that businesses make in exchange for the factors of production. A wage, for example, is the cost businesses incur when they employ workers. Businesses also pay for other factors of production such as capital goods and natural resources. The oil price shocks of the mid-1970s and late 1970s showed how higher resource costs, in this case a higher price for crude oil, pushed prices higher for many products in the United States. In 1972 the annual inflation rate stood at just 3.2 percent. During the first oil price shock, the U.S. inflation rate hit 6.2 percent in 1973, 11 percent in 1974, and 9.1 percent in 1975. Similarly, the second oil price shock contributed to double-digit inflation rates of 11.3 percent in 1979, 13.5 percent in 1980, and 10.3 percent in 1981.