Hi simontempler!
The usual explanation for the rise of interest rates in 1978-1982 is
the crowding out of private borrowers by the US government. Let me
clarify. Governements have basically three sources of income to
finance their expenses. These are:
a) Taxes
b) Printing currency
c) Borrowing
Now consider some of the government objectives durin the Ronald Reagan
term. The US had inherited a high inflation rate from the '70s; so
Paul Volcker (president of the Fed in those years) wanted to reduce
it. The usual way to reduce the inflation rate is by adopting a
contractive monetary policy, that is, by lowering the rate at which
new money is printed. This puts a restriction on the source of income
(b) I mentioned above. At the same time, Reagan wanted to fulfill his
promises of tax cuts, so tax rates were also lowered. Source of income
(a) was thus reduced. Finally, Reagan combined this lower government
income with higher government expenses, mainly due to an increasing
Defense budget (the so-called "Star Wars" program). The result should
now be obvious. It was not possible to cover these expenses with taxes
or inflation, so the government had to borrow funds in order to
finance its deficit. Thus, demand for funds increased. If we assume
that funds supply did not experience major changes (it didn't), then
as public demand for funds increased, private borrowers needed to bid
more (i.e., pay a higher interest rate) in order to get the funds they
wanted.
This is the most widely accpeted explanation: a combination of low
taxes, low money growth rate and high expenses, which caused a large
budget deficit that led to an increasing debt level, which pushes
interest rates upwards.
I hope this explanation was clear to you. If you need any further
clarification, please don't hesitate to request it.
Best wishes,
elmarto |
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