This has become a serious question. With President Trump doubling down on tariffs, it seems certain that more will be imposed. That means the average price level will rise. The question is, “What should the Fed do?” In other words, what should monetary policy 2025 look like?
That question was posed on twitter by user @MartyPartyMusic. He wrote
FOMC Statement: I called it. QT starts ending April 1st.
Here’s his complete post. He used the January statement as a base, then edited it to reflect the March statement. (The Fed uses much the same language in every FOMC statement.)
(click for larger image)
To those wondering, QT stands for quantitative tightening. In other words, Marty expects the Fed to raise their target interest rate soon. They will accomplish this by selling assets (historically, U.S. Treasury securities, but we’ve been in uncharted waters since the 2008 financial crisis, so who knows?)
To answer this, let’s go back to a historical event that literally rewrote the book on macroeconomic policy: the OPEC oil price increases of the 1970s.
The History
Begin in 1967. That’s two years before I graduated from college. It’s also the year I was named editor of the student newspaper. This is a personal account.
The US was torn by the Vietnam war. President Lyndon Johnson was very much in favor of continuing the war. In fact, he was selecting bombing targets. (No, I’m not kidding.) But he also wanted to start the War on Poverty. And he did not want to raise taxes.
Johnson’s chats with his economic advisers are rumored to have gone something like this:
LBJ: We’re gonna continue the Vietnam war, start the Great Society program [the war on poverty], and not raise taxes.
Economists: But you’ll wreck the economy.
LBJ: To hell with the economy.
In 1967 the economy was at full employment with low inflation. The standard economic model looks like this:
Notation:
y: real GDP growth
π: inflation rate
yf: full-employment real GDP growth
AD: aggregate demand
SAS: short-run aggregate supply
LAS: long-run (full employment) aggregate supply
The Beginnings of Inflation
Fighting two wars at the same time is expensive. Sure enough, the economy was overheated in short order. Aggregate demand increased, output rose above potential GDP, and unemployment dipped below the full employment rate. In our framework, here’s what that looks like:
The beginnings of the 1970s disaster were bad economic policies in Washington, DC. Turns out President Johnson’s economists were absolutely correct. For better or worse, our role in national politics remains strictly advisory.
OPEC Steps In
In 1960, a group of oil-producing countries got together to form a cartel in the global oil market. While cartels are illegal in many countries, no one had ever seen anything quite like OPEC. The original members were Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. Surprisingly, Saudi Arabia was the number two producer, 1.31 million barrels per day (mbd). Kuwait was the leader at 1.69. Total OPEC production was 8.27 mbd but non-OPEC output was 12.72 mbd. Among the non-OPEC countries, the US pumped 7.04 mbd, over half that group’s output. (Data available here.)
Market share data is interesting. In 1960 OPEC’s share of global oil output was 39.4%. Non-OPEC was 60.6%. In 2009 the OPEC share was 42.4%. OPEC’s market share was over 50% only during the decade 1970-1980. That small piece of additional market power seems to have made all the difference in the world. Literally. OPEC tripled oil prices twice during the decade of the 1970s. That was the beginning of supply-side economics. A large increase in the price of any production input that is used widely across many industries shifts the short-run aggregate supply curve up and to the left (SAS1974).
Fig 04 Oil price shocks
When most people think of oil, they think of motor vehicles: gasoline and crankcase oil (as well as other lubricants). But all plastics begin as oil. So do many solvents. To some extent, oil is everywhere.
Let’s let OPEC tell its own story:
OPEC rose to international prominence during this decade, as its Member Countries took control of their domestic petroleum industries and began to play a greater role in world oil markets. The decade witnessed several impactful events that caused volatility in the global oil market to rise steeply. OPEC broadened its mandate with the first Summit of Heads of State and Government in Algiers in 1975, which addressed the plight of the poorer nations and called for a new era of cooperation in international relations, in the interests of world economic development and stability. This led to the establishment of the OPEC Fund for International Development in 1976. Member Countries embarked on ambitious socio-economic development schemes. Membership grew to 13 by 1975.
OK, that’s just a little self-serving. In fact, OPEC tripled the global price of oil twice during the 1970-1979 decade. This was a massive upward shift in the short-run aggregate supply curve. Before we get to the model, we need a bit of history.
A Little History of Economic Thought
At the beginning of the 1970s economists were suffering from extreme hubris. The profession believe they understood the economy so well they could fine-tune it. As always, hubris leads to downfall.
In fall, 1973, I entered the Stanford economics PhD program. Prof. Duncan Foley taught first quarter macroeconomics. We read and discussed Keynes’s “General Theory of of Employment, Interest, and Money.” At one point during the quarter, one of my fellow students asked, “What ever happened to fine-tuning?” Foley replied, “Well, now we’re concerned with gross tuning.”
What economists in the 1960s failed to take into account was aggregate supply. Models were based mostly on aggregate demand. During the 1970s the profession was mainly engaged in two activities: consuming vast quantities of humble pie and incorporating supply into their models. The OPEC price increases were negative supply shocks. The short-run aggregate supply curve shifted up and to the left. This led to a condition called stagflation: high inflation (11.04%) and high unemployment (output growth of -0.54% and an unemployment rate of 5.60%). For the data, click here for the Excel workbook (including a few graphs).
Back to Our Model
Here’s what that looks like. High inflation and output below full employment.
The Federal Reserve was faced with an impossible tradeoff. They could fight unemployment, but only at the cost of higher inflation (ADU).
Or they could fight inflation but unemployment would increase (ADI).
The Fed chose a compromise, increasing aggregate demand but not by enough to get the economy back to full employment. That would have created much higher inflation.
The problem was (and is) both fiscal and monetary policy affect only aggregate demand. There are no policy tools to manipulate aggregate supply.
Implications for Current Policy
Tariffs are also supply shocks. They increase the price of an input. In this case, the “input” is the price the government collects as a tariff. But the lessons from the 1970s are clear. We still have no policy instruments to shift the short-run aggregate supply curve. And, given the nature of aggregate supply, finding a policy instrument that affects AS seems unlikely. But there is one that would work.
Meet WIP
Around 1978 I attended a talk by Prof. Abba Lerner. Dr. Lerner is known for discovering economic rules of thumb. Perhaps the best-known is the Lerner Index, a measure of market power:
But he is perhaps best known for his rules of functional finance:
… the government [should maintain] “a reasonable level of demand at all times” through appropriate fiscal policy, and a monetary policy governed only by the need to maintain “the optimal amount of investment” and by the functional needs of the economy, not by any precepts of “sound finance.”[1]
Here, we’re more concerned with aggregate supply. Dr. Lerner observed that there are two kinds of paper used to regulate the economy: money and government securities. The former are issued by the central bank. Government securities finance government deficits. Both affect aggregate demand. We need a piece of paper that can influence aggregate supply.
He called these slips of paper “wage-increase permits.”[2] Here’s Dr. Lerner’s description:
WIPP works as follows:
(1) The government would grant “wage increase permits” to every employer who qualified by employing more than, say, 100 workers or any workers whose wages were fixed b an agreement that covered more than 100 workers-for instance, one permit for each $1,000 of the employer’s total costs of employment (called his “wage bill,” but including all fringe benefits and so forth). Records would be kept of the employer’s wage bill from a base date, including each employee’s wages (pay plus the employee’s share of the other costs of employment).
(2) Newly hired employees, including all employees of new firms, would enable their qualified employers to obtain additional permits and also a permit for each $1,000 of the new employee’s wages. Conversely, on the separation of an employee from a firm, including all the employees of a firm that closes, the corresponding number of permits would have to be returned to the permit authority. This would adjust the total number of permits to changes in the wage bill that were due to changes in employment, rather than to changes in the wage level.
(3) Each permit would give the employer who held it the right (by raising wage rates) to raise his adjusted wage bill by, say, $30 per permit (3 percent of the face value of his permits, which is the estimated national average rate of increase in output per employee-“productivity”).
(4) The permits would be freely tradable in a perfectly competitive market, like a share of IBM in the stock exchange. Any employer who wished to increase his adjusted wage bill by more than 3 percent by raising wage rates would have to acquire more permits. He could obtain them only through purchase from others who had to reduce the increase in their wage bill by the same amount below 3 percent. Any employer who reduced his wage bill would qualify for a grant of additional permits for the corresponding amount (one permit for each $30 cut from a wage bill), and could sell those permits. The national total wage bill would thereby always be raised just 3 percent a year by the wage bill increases of the different firms. Because the wage bill is adjusted for changes in employment at the level of the firm and at the national level, the national average wage would continue to rise at 3 percent a year. The price of the permit would be set by the market at the level at which supply equals demand; this price would just offset inflationary expectations for raising wages more than productivity
You get the idea. Presumably the government would set up another agency similar to the Federal Reserve. Let’s call it WIPout (pronounced “wipeout,” acronym for wage increase permit outfit). That agency would be responsible for enforcing market rules and issuing new WIPs.
Naturally, this is all hypothetical. There is no way unions would let WIPout be created. The WIP scheme remains a historical novelty.
- Colander, David (2004). “From Muddling Through to the Economics of Control: View of Applied Policy from J.N. Keynes to Abba Lerner.” Middlebury College Economics Discussion Paper No. 04-21, September 2004. Department of Economics, Middlebury College, Middlebury, Vermont 05751. Available at https://community.middlebury.edu/~colander/articles/From%20Muddling%20Through%20to%20the%20Economics%20of%20Control.pdf. Accessed April 13, 2025. Lerner quotations from ‘The Economic Steering Wheel” The University Review, June 1941 ↑
- Lerner, Abba (1978). “A Wage-Increase Permit Plan to Stop Inflation.“ Brookings Papers on Economic Activity, 1978, No. 2. Available at https://www.brookings.edu/articles/a-wage-increase-permit-plan-to-stop-inflation/. Accessed April 13, 2025.↑
