As I noted earlier, both the macroeconomic framework of the 1970s and the general understanding of monetary policy have undergone notable changes. Nonetheless, the US experience demonstrates how quickly inflation expectations can drift upwards if actual inflation is persistently above the stability norm of the central bank and if, consequently, market participants lose confidence in the central bank’s will to restore price stability.
Another explanation of the Great Inflation focuses on the Fed’s response to output. 2 This view does not regard the Fed’s weak response to inflation as problematic, but the importance it attached to output stabilisation. Indeed, a strongly activist monetary policy, which strives to keep the economy close to potential, suffers from a fundamental conceptual problem.