The 1970s marked an unprecedented change in interest rate behav-
ior. Inflation reached double-digit levels, and interest rates soared to
heights that had not been seen since the debasing of the continental cur-
rency in the early years of the republic. Never before had inflation been
so high for so long.
The public clamored for government action to slow rising prices.
Finally, by 1982, the restrictive monetary policy of Paul Volcker, chair-
man of the Federal Reserve System since 1979, brought inflation and in-
terest rates down to more moderate levels. One can see that the level of
interest rates is closely tied to the level of inflation. Understanding the
returns on fixed-income assets therefore requires knowledge of how in-
flation is determined.THE END OF THE GOLD STANDARD AND PRICE STABILITY
Consumer prices in the United States and the United Kingdom over the
past 200 years are depicted in Figure 1-3. In each country, the price level
at the end of World War II was essentially the same as it was 150 years
earlier. But after World War II, the nature of inflation changed dramati-
cally. The price level rose almost continuously during that 60-year pe-
riod, often gradually, but sometimes at double-digit rates as in the 1970s.
Excluding wartime, the 1970s witnessed the first rapid and sustained in-
flation ever experienced in U.S. history.
The dramatic changes in the recent inflationary trend can be easily
explained. During the nineteenth and early twentieth centuries, the
United States, United Kingdom, and the rest of the industrialized world
were on a gold standard. As described in detail in Chapter 11, a gold
standard restricts the supply of money and hence the inflation rate. But
from the Great Depression through World War II, the world shifted to a
paper money standard. Under a paper money standard there is no legal
constraint on the issuance of money, so inflation is subject to political as
well as economic forces. Price stability depends on the ability of the cen-
tral banks to limit the growth of the supply of money in order to coun-
teract deficit spending and other inflationary policies implemented by
the federal government.
The chronic inflation that the United States and other developed
economies have experienced since World War II does not mean that the
gold standard was superior to the current paper money standard. The
gold standard was abandoned because of its inflexibility in the face of
economic crises, particularly during the banking collapse of the 1930s.
The paper money standard, if properly administered, can prevent theCHAPTER 1 Stock and Bond Returns Since 1802 9