We show that severe credit crunches in the banking system contributed to the stagflation of the 1970s. The credit crunches were due to Regulation Q, which im- posed hard ceilings on bank deposit rates. Reg Q became binding when the Fed raised interest rates. This led to outflows of deposits and a contraction in bank lending. Since firms rely on credit to produce output, the lack of credit forced firms to raise prices and cut output and employment, i.e., they led to stagflation. Consistent with this hypothesis, we find a tight relationship between declines in deposits and bank credit, the buildup of unfilled manufacturing orders and inflation, and declines in GDP growth, employment and inflation. We then test our hypothesis in the cross section of manufacturing industries sorted by their dependence on bank financing. We find that during the credit crunches finance dependent industries raised prices and cut output by more than other industries. We find similar results when we sort industries based on the extent to which Reg Q was binding for their lenders. Our findings imply that monetary policy affects aggregate supply and not just aggregate demand. The extent to which it does so depends on frictions in the financial system.

Professor Itamar Drechsler is an Ervin Miller and Arthur M.  Freedman Professor of Finance in the Faculty of Wharton at University of Pennsylvania. His main research areas are asset pricing, financial intermediation, macro finance, and monetary policy. His research has been published in top economics journals such as Journal of Financial Economics, Journal of Finance, Annual Review of Financial Economics, Quarterly Journal of Economics, Journal of Finance, and Journal of Monetary Economics. He obtained his Ph.D. in finance from University of Pennsylvania in 2009.