We show that severe credit crunches in the banking system contributed to the Great Stagflation of the 1970s. The credit crunches were due to Fed tightening in the
presence of a large financial friction: Regulation Q, a banking law that capped deposit rates. Reg Q became binding whenever the Fed raised rates, leading to large outflows of deposits and a contraction in bank lending – a credit crunch. Since firms need credit to produce, the credit crunches acted as negative supply shocks, forcing firms to raise prices and cut output (stagflation). We find that the Reg Q credit crunches align closely with the stagflation cycles in the time series: when Reg Q binds, deposits flow out and bank loan supply shrinks, firms’ order backlogs increase, prices rise and output falls. To test the hypothesis that the Reg Q credit crunches led to stagflation,we compare industries based on their dependence on external financing. We find that
during the credit crunches finance dependent industries raise prices and shrink output relative to other industries. We find the same result for industries located in areas
where banks are more exposed to Reg Q, especially if these industries are finance dependent. Our findings imply that when raising rates cuts off credit to firms, monetary policy affects aggregate supply and not just demand.