Credit Crunches and the Great Stagflation

We argue that severe credit crunches in the banking system contributed to the Great Stagflation of the 1970s. The credit crunches were due to Regulation Q, a banking law that capped deposit rates. Under Reg Q, Fed tightening triggered large deposit outflows that led banks to contract lending. The credit crunches line up closely with stagflation in the time series. To explain this, we add Reg Q to a standard model where firms use bank loans to finance working capital. When Reg Q binds and credit contracts, working capital becomes more expensive, leading firms to raise prices and shrink output. The model implies an augmented Phillips curve where monetary tightening reduces aggregate supply in addition to demand. The impact on supply is increasing in the severity of the credit crunches, firms' external finance dependence, and their working capital intensity. We test all three predictions in the cross section of manufacturing industries. In each case, we find that more exposed industries raise prices and cut output relative to others. Our results imply that under severe financial frictions monetary policy affects aggregate supply and not just demand.