Stagflation

Updated on January 31, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Stagflation Meaning

Stagflation is an economic scenario where stagnation coincides with inflation. The stagnation of the economy is caused by rising unemployment. Therefore, it is also known as recession-inflation. 

During stagflation, the gross domestic productGross Domestic ProductGDP or Gross Domestic Product refers to the monetary measurement of the overall market value of the final output produced within a country over a period.read more (GDP) goes down, and the prices of necessary commodities go up. It is a complicated predicament for governments and policymakers as measures taken to control inflation will also increase unemployment.

Key Takeaways

  • Stagflation refers to an economic phase where inflation increases while the gross domestic product becomes constant or low. Additionally, the employment level plummets.
  • It proved the Keynesian macroeconomic theory wrong, which explained the trade-off between unemployment and inflation.
  • In the 1970s, the United States struggled with stagflation. The Federal Reserve Chairman Paul Volker took necessary steps in 1979. He implemented various contractionary monetary policies. He managed to bring down the inflation rate.

How does Stagflation Work?

Stagflation

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Stagflation is a phenomenon that overrules the supply and demand concept. It opposes the model proposed by the Keynesian EconomistsKeynesian EconomistsKeynesian Economics is a theory that relates the total spending with inflation and output in an economy. It suggests that increasing government expenditure and reducing taxes will result in increased market demand and pull up the economy out of depression.read more with respect to gross domestic product and its correlation with inflation. Stagflation is nothing but economic stagnation coinciding with inflation, that is, stagnation + inflation = stagflation.

A nation facing stagflation goes through high commodity prices, lessened purchasing power, poor GDP, business shutdowns, a decline in consumer spending, and escalation of unemployment brought out by corporate layoffs. The US went through stagflation in the 1970s. Many economists blame the Federal Reserve’s extravagant money supply and circulation for the economic debacle. The motive behind increasing cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more was a strategy to improve labor market conditions. In addition to the policy, the US was hit with a sudden rise in oil prices. This was brought out by the Arab embargoEmbargoAn embargo is a political decision taken by countries where the government passes an order to restrict the free trade of goods & services between two nations for a specified period and may include restricting all types of goods & services or trading of particular interest like oil.read more to the US. Middle-eastern countries stopped supplying to the US. As a result, the 1970s US was suffering from inflation and recession at the same time.

Countries dread stagflation: it is tricky to handle. Measures taken to control inflation will further increase recession. But, on the other hand, if steps are taken to improve employment, it further increases inflation. If such a situation persists in the long run, the nation may end up with a high level of poverty and unemployment with decelerated progress.

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Causes of Stagflation

The most significant cause behind such an economic scenario is monetary policyMonetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more. Past instances of inflation-recession highlight this. Wrongly devised fiscal policiesFiscal PoliciesFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. read more can have a drastic impact. Sometimes, the central bank induces an excessive money supply to reduce unemployment and improve the GDP. The rising inflation in return increases commodity prices and depreciates the currency’s purchasing power.

To tackle the issues, governments increase taxes. This is done mainly to deal with and reduce commodity prices. These two different forms of measures, if adopted together in the long run, have a significant adverse effect on the economy. The worst-case scenario is high inflation with a parallel recession.

Another contributing factor could be a supply shock. The US faced a shocking cut-off of oil supply in 1973. Middle-eastern countries ceased the supply of oil to the US. As a result, the economy slowed down while prices kept rising. Similarly, the supply of goods and services can also be obstructed by natural disasters, sudden weather conditions, political unrest, or war. These mishaps lead to a rise in prices, and inflation follows subsequently.

Stagflation in the 1970s

Inflation always has an opposite impact on unemployment; a rise in inflation is expected to bring down unemployment. It was stated under the Keynesian economists’ model and was a widely accepted economics phenomenon before the 1970s.

In the 1970s US faced stagflation. The Federal Reserve’s expansionary monetary policiesExpansionary Monetary PoliciesThe central bank uses expansionary monetary policy to increase the supply of money while lowering the interest rate and increasing demand. This is done to boost a country's economy.read more were introduced to reduce unemployment, but it backfired and caused inflation. Anticipating better employment conditions, the Fed continuously increased the money supply. The problem is that the monetary injection surpassed the pace of economic growthEconomic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific period.read more. To make matters worse, people started stocking goods. All this together led to a 10% inflation rate early on in the 1970s. This was drastically high from just 2-3% inflation rate in the late 1960s.

The 1973’s energy supply shock, which popped up with the Arab oil embargo to the US, significantly slowed down the American economy. It was amidst the energy crisis that the fuel prices went up. Unemployment was a natural consequence of businesses shutting down. All these circumstances contributed to a period of massive inflation with significant recession. It was in August 1979 that Paul Volcker took charge as Federal Reserve Chairman. He took strict contractionary measures to reduce inflation. He significantly increased the banks’ Federal Funds Rate. Gradually the correction measures worked. Inflation was finally under control.

Many financial analystsFinancial AnalystsA financial analyst analyses a project or a company with the primary objective to advise the management/clients about viable investment decisions. They do a thorough financial analysis and make suitable objective projections to arrive at their conclusions.read more fear a repeat of stagflation in 2021. The US markets risk a similar economic debacle. During the covid crisis, the Fed eased out its monetary policies to ensure labor marketLabor MarketThe labour market, also known as the job market, is a well-studied market that operates on the supply and demand dynamics of people looking for work (workers) and organizations/people providing work (employers).read more improvement. However, there was stagnant economic growth and a high level of unemployment. Increased cash flow during recession hints at possible inflation in 2021. 

Why is it considered bad?

Stagflation is a double-edged sword that adversely affects the economy. Moreover, the measures taken to control inflation will cause increased unemployment. Similarly, measures taken to consolidate unemployment will increase inflation. Unlike inflationInflationThe rise in prices of goods and services is referred to as inflation. One of the measures of inflation is the consumer price index (CPI). Rate of inflation = (CPIx+1–CPIx )/CPIx. Where CPIx is the consumer price index of the initial year, CPIx+1 is the consumer price index of the following year.read more and deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more, there is no standard format to deal with inflation-recession.

During this economic situation, everything becomes expensive, the purchasing power of money drops. Rather than spending on leisure and lifestyle, people stick to basic requirements. Thus, the demand for such goods falls significantly. As a result, companies face losses. Reduced profit in turn starts a chain reaction. Wages get cut, employees get laid down, and ultimately businesses get shut down. The nation’s GDP goes down; recession coincides with inflation.

Inflation-recession has a few positive impacts too. Traders involved in selling gold, oil, and other such products can benefit from the commodity’s price rise.

Frequently Asked Questions (FAQs)

What is Stagflation?

Stagflation is a phase of economic hardship where inflation coincides with unemployment and falling gross domestic product (GDP). There is no set mechanism to deal with stagflation; government can only address the root cause of inflation and deal with it. The corrective measures to control inflation can help, but the government has to make sure that unemployment does not rise too rapidly. Over a period of time, inflation-recession corrects itself.

What causes stagflation?

The various reasons behind the occurrence of stagflation include:
• An unanticipated rise or fall in commodity supply. This could be caused by weather changes, natural calamities, and increasing commodity prices.
• Confusing government fiscal decisions and the central bank’s monetary policies also cause inflation-recession. These policies include excessive printing of money and rising interest rates and taxes.

What happens to the economy during stagflation?

Following are the various impacts of stagflation on the economy:
• Decline in economic growth, i.e., gross domestic product (GDP);
• Increase in corporate layoffs;
• Increased unemployment;
• Rise in price of goods and services;
• Fall in consumer spending;
• Decrease in purchasing power of money.

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This has been a guide to Stagflation and its Meaning. Here we discuss recession-inflation, its causes, 1970s US stagnation, why it is considered bad, and how it works. You can learn more about financing from the following articles –

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Comments

  1. Irfan Shaikh says

    the first example of UK that you gave is very much identical with demonetisation in India…..

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