In normal times, if there is such a thing, lowering interest rates makes borrowing cheaper and the increased spending that results, increases demand. In such a situation, one would expect the increased demand to put pressure on increasing prices all else being equal.
In the 1970’s, the situation was different.
Here is how I understand it.
An increase in spending (demand) led to decreased unemployment and as unemployment decreased workers bargaining power increased, and they were able to demand and get wage increases.
Since it was not a perfectly competitive market, the amount of monopoly power that employers possessed allowed them to follow wage increases with price increases, to protect their excess profits or economic rents.
Those price increase reduced the buying power of their new wages and as workers saw their buying power reduced by the price increases they again negotiate for and obtain higher wages.
This led employers to again raise prices, which was followed by more wage increases, followed by more price increases etc. This process could continue as long as workers have bargaining power and employers have some degree of monopoly power, and so inflation could continue to be driven up.
As prices go up, interest rates will have to follow, or banks will be taking a loss, in real terms. So in the 1970’s you had inflation go up first and interest rates followed.
But another thing occurred in this process. Those workers who were in a position to bargain for pay raises had their wages go up. But large segments of the population would not be able to bargain the same way and large segments of the population would see the buying power of their income reduced. Fixed income earners, retirees, pensioners, some types of jobs, the unemployed, welfare recipients etc. They would be losing ground in terms of real purchasing power, so that even if certain workers pay was able to keep pace with inflation, even if certain workers REAL incomes kept pace with this excess inflation, OVERALL in the economy, REAL, inflation adjusted incomes would be reduced. This reduction in REAL demand would lead to job loss and increased unemployment. That gives the situation called stagflation where we have both high inflation and high unemployment at the same time.
That is the demand side explanation for stagflation, which I believe is the correct explanation.
To correct excess inflation, despite the increased unemployment associated with stagflation, the intervention used was to lower demand by increasing the federal funds interest rates. This worked by increasing unemployment further and decreasing workers bargaining power further. Eventually the decreased demand could allow inflation to be reduced. There did not appear to be any focus on also reducing monopoly power as a way to reduce excess inflation.
These two charts show how during two periods of recession in the 1970’s that first inflation rose, and this is followed by unemployment levels rising rapidly. As the unemployment is going up, the inflation rates begin to fall. This is consistent with excess inflation leading to decreased real demand and a rise in unemployment rates. The higher unemployment rates would lead to reduced workers bargaining power and slow price increases.
In between as unemployment goes down, prices rise again.
United States, Inflation, 1964 to 1982 World Bank, Inflation, consumer prices for the United States [FPCPITOTLZGUSA], retrieved from FRED, Federal Reserve Bank of St. Louis; Inflation, consumer prices for the United States November 25, 2018
United States, Unemployment Rate, 1964 - 1982 U.S. Bureau of Labor Statistics, Unemployment Rate: 20 years and over [LNS14000024], retrieved from FRED, Federal Reserve Bank of St. Louis; https:// Unemployment Rate: 20 years and over November 25, 2018.
FRED® Graphs ©Federal Reserve Bank of St. Louis. 2018. All rights reserved. All FRED® Graphs appear courtesy of Federal Reserve Bank of St. Louis.
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