Stagflation

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21 Aug, 2024

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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 product (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.

Stagflation Meaning

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 is a phenomenon that overrules the supply and demand concept. It opposes the model proposed by the Keynesian Economists 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 flow 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 embargo 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.

Causes of Stagflation

The most significant cause behind such an economic scenario is monetary policy. Past instances of inflation-recession highlight this. Wrongly devised fiscal policies 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 policies 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 growth. 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 analysts 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 market 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 inflation and deflation, 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.