Paul Volcker

What were the strengths and weaknesses of the Fed's operating procedures that were used after October 6, 1979?

In 1979, two factors impacted inflation. The oil shock resulted in prices spiraling out of control. With higher production costs, the companies have to maintain profits margins by increasing prices to consumers (inflation). In addition, the weakness of the US dollar aggravated inflationary pressures as well. The weak dollars results in rising of the price of imports and reducing the price of exports. The overall exports increases since US goods are relatively inexpensive. This in turn raises demand and increases inflation. In order to control inflationary pressures, the Fed put in policies that reduced the money supply.

In 1979, Volcker increased the discount rate and introduced new marginal reserve requirements. All of this resulted in the contraction of the money supply. This in turn results in the increase in the prime rates, which results in a reduction in inflation. Higher interest rates discourage borrowing by companies and individuals. Since both companies and individuals both have lower disposable incomes now, they will reduce both private and business investments. Since the cost of spending has increased, rate of savings increases which also reduces the overall money supply.

Slowing down the economy has some great risks as well. If Volcker's decisions are too aggressive, a recession could result. With high interest rates, borrowing money becomes expensive. People are not tempted buy things, therefore this result in a drop in demand. Then the supply of goods becomes high and production has to decreases due to a lower demand. When production decreases, the demand for labor decreases (unemployment increases) and a recession results.

In addition, another negative part of high interest rates is the impact on the bond market. As interest rates increased, the bond value dramatically dropped causing financial hardship on the financial institutions that bought the bonds.