Stagflation is defined as an economic phenomenon where there is high inflation along with rising unemployment and relatively slow economic growth or recession. In this condition, there is a slowdown in the gross domestic product (GDP) and an increase in the prices of necessary commodities. In other words, it is the economic scenario where there is co-existence of recession and inflation side by side.
The reasons for these unfavorable conditions are the government’s failure to cope with inflation, which tends towards unemployment. When the government’s policies backfire, it tends to create a contradictory course of action in an economy. Various factors like supply shocks and poor implementations of fiscal policies are the primary reasons for this phenomenon.
Components of Stagflation in Economics
The primary components of stagflation are mentioned as follows:
- Higher rate of unemployment
- Low GDP
- Recession in most of the economic activities and
- Poor implementation of government policies
Examples of Stagflation in Economics
Let’s see some examples of stagflation to understand it better.
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Suppose, the United Kingdom is experiencing a higher wage rate, higher inflation, and higher economic growth. Thus, the situation of stagflation is mentioned step by step.
- To curve the inflation in the economy, the central bank of the country has decided to stop the supply of money within the economy.
- Thus, the first and foremost effect would hit the consumer’s pocket. Consumers would feel the pinch and thereby consumer spending would decrease drastically.
- Fall in consumer spending would automatically reduce demand for consumer goods and services, and hence the overall business scenario would likely dampen.
- The firm’s profit would tend to decrease instantly and there would be cost-cutting techniques adopted by the firms.
- Cost-cutting techniques like lay-offs which would lead to unemployment, reduction in overall productions and there will be supply cut and these would lead to a higher demand for commodities.
- Thus, another reason for inflation would be the demand-supply mismatches. Until the new policy is adopted, the cost will remain moderately low whereas the prices will tend to remain at the same level. Thus the price gap would follow along with unemployment and recession. This situation will continue until the government policies are well implemented, and the economy revives along with corporate earnings.
During the early 1970s, the US economy was going through a series of slowdown across manufacturing, industry, and corporate earnings. The primary reasons were due to several failures in implementing social as well as fiscal policies by the US Federal Reserve. After the boom in the 1950s and 1960s, the economy went through the nest cycle of recession, where inflation and unemployment were sustained side by side.
The supply shock occurred during stagflation. The phenomenon started with a reduction in the quantity of oil which acted as a knee jerk to the society and the price of oil went sky high. As oil is indirectly and directly related to most of the commodities, the cost of those commodities tends to rise abruptly. Due to poor implementation of fiscal policies, the economy could not stay out of the stagflation resulting in diminishing income, higher unemployment, and a decrease in corporate earnings and real income.
Advantages of Stagflation
Some advantages of stagflation are as follows:
- The overall expenses of the business houses tend to decrease due to cost-cutting techniques. The firm earnings tend to increase for a while when the income remains stable.
- For the time being, the prices of the products remain the same which results in margin improvement. However, volumes tend to decrease drastically.
- The intrinsic value of the local currency tends to increase for a while due to supply constraints.
- Prices of commodities like gold, silver tend to rise whereas prices of aluminum tend to decrease.
- Handfuls of traders who are trading in oil, gold, etc tend to generate huge profits due to an appreciation of the commodity prices. Whereas the general market scenario remains negative.
Disadvantages of Stagflation
Some disadvantages of stagflation are as follows:
- The purchasing power of the general population decreases and the major part of the population spending goes to the basic commodities.
- The prices of the commodities tend to be high when the real value of the currency is considered.
- Demand for basic commodities stays at the same level, whereas demand for luxury items tend to diminish drastically.
- Earnings of most of the firms tend to decrease along with margin and output.
- Higher unemployment due to factory lay-offs and pay cuts in wages are the primary characteristics of stagflation.
- The GDP tends to decrease as the recession takes the front seat within the economy.
- The inflation rate increases as the prices of the commodities remain at previous levels and the real purchasing power of common people diminishes.
Limitations of Stagflation
Some limitations of stagflation are as follows:
- Due to the stagflation earnings of the firms stay in the same range or sinks.
- The real income of the consumer diminishes as unemployment continues to grow.
- The government fails to eradicate inflation and revive the economy, as most of the policies implemented in an unorganized manner.
- The flow of currency within the economy is checked by the central bank, which causes a fall in the real income of masses.
- Inflation and unemployment remain side by side, which causes tremendous pressure to the economy.
- Stagflation is very difficult to eliminate as contrasting characteristics do occur side by side. The central banks of each country have to take several bold steps to eradicate it fully.
Till 1970, economists used to believe that inflation and unemployment do not occur side by side. But after that, Keynesian economists were convinced about the co-existence contradictory features like inflation and unemployment. When industrialized countries like us entered into a recession zone along with high unemployment, economists discovered that this is an uncommon scenario which is very difficult and most of the time central banks have to take severe decisions to combat the crisis. One of the major drivers of the situation is the checking of liquidity within the economy. This type of phenomenon occurs right after prolonged years of economic boom. The down cycle evolves right after the upcycle or boom in the economy. Thus stagflation remains in between the above two phenomena.
This has been a guide to what is stagflation and it’s definition. Here we discuss components, examples of stagflation in Economics along with limitations, advantages, and disadvantages. You can learn more about financing from the following articles –