Economists typically focus on the three big macroeconomic variables: gross domestic product (GDP) , unemployment and inflation. Each measure tells its own important story about how the economy is doing.
Under normal circumstances, economy usually can’t have a strong pace of GDP growth and low unemployment without suffering the pains of higher inflation . And if you’re able to keep inflation low, that usually comes at the expense of subdued GDP and possibly higher unemployment.
So, normally with these variables combination there is some good news and some bad news. But with stagflation, there is no good news.
So, what is Stagflation?
Stagflation happens when the economy is experiencing both stagnation of economic output (decline in the GDP) and increase in inflation. Additionally, a struggling economy will drive up unemployment.
In other words, all three above mentioned macroeconomic indicators are going in the wrong direction.
Under period of stagflation, households and businesses begin to worry that inflation will continue to soar over the long haul, which becomes a self-fulfilling prophecy, causing them to adjust their economic behavior in a way that ensures inflation will continue.
Stagflation is often confused with recession . One aspect of stagflation is low or stagnant growth in economic output, whereas in a recession, economic output declines. Another difference: Normally a recession leads to low inflation or even a cut in prices for goods and services, whereas stagflation comes with high inflation.
History of stagflation
The term "stagflation" was first used by politician Iain Macleod in the 1960s during a time of economic stress in the United Kingdom. He wrote "We now have the worst of both worlds - not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of “stagflation” situation." It was later used again to describe the recessionary period in the 1970s following the oil crisis when the U.S. underwent a recession that saw five quarters of negative GDP growth. Inflation doubled in 1973 and hit double digits in 1974; unemployment hit 9% by May 1975.
What Causes Stagflation?
The causes of stagflation are still hotly debated by economists. Before the 1970s, they generally didn’t believe it was possible to have both high inflation and high unemployment from a stagnating economy. Economists had thought that unemployment and inflation were inversely linked.
However, there are a few different theories on how both high inflation and a stagnating economy can coexist. The most common is that stagflation happens when there is a so-called negative supply shock. That is, when something that is crucial to an entire economy, such as energy or labor, is suddenly in short supply or becomes more expensive. One obvious example is crude oil. Oil is a key input into the production of many goods and services. When some unexpected event, like the Russian invasion of Ukraine, reduces the supply, the price of oil rises. Worldwide businesses that produce gasoline, tires and many other products experience rising transportation costs.
As a result, a great number of producers decrease their production, which decreases aggregate supply. This decrease leads to falling national output and an increased unemployment rate together with higher overall prices.
A second theory states is that stagflation happens in cases of falling productivity, where workers, by becoming more inefficient, cause costs to rise and outputs to fall.
How Bad is Stagflation?
Stagflation combines two situations that are normally contradictory, namely rising prices and falling economic output. This is why this phenomenon is considered very bad and damaging—an increase in the unemployment level results in a decrease in consumer spending power. If you tack on runaway inflation, that means that what money consumers do have is losing value as time goes by—there is less money to spend and the value of the money stagnate or is in decline.
Exacerbating the situation is that stagflation creates difficulties for policymakers: Policies that could cure inflation are likely to worsen economic output, and vice versa .
How to handle Stagflation?
Stagflation is very difficult for policy makers and there is no definitive cure and solutions for stagflation. For example, the Central Bank can increase interest rates to reduce inflation or cut interest rates to reduce unemployment. But, they can’t tackle both inflation and unemployment at the same time.
The consensus among economists is that productivity has to be increased to the point where it would lead to higher growth without additional inflation. This would then allow for the tightening of monetary policy to rein in the inflation component of stagflation. One more solution is to make the economy less vulnerable to stagflation is to reduce the economies dependency on oil. Rising oil prices are the major cause of stagflation.
All above mentioned is easier said than done, so the key to preventing stagflation is to be extremely proactive in avoiding it.
What Is real life Example of Stagflation?
In the early 1970s, the post-World War II economic boom began to wane in US, due to increased international competition, the expense of the Vietnam War, and the decline of manufacturing jobs.
Unemployment rates rose, while a combination of price increases and wage stagnation led to a period of stagflation.
In 1964, when this story began, inflation was 1 % and unemployment was 5 %. Ten years later, inflation would be over 12 % and unemployment was above 7 %. By the summer of 1980, inflation was near 14.5 %, and unemployment was over 7.5 %.
The crisis was compounded when oil-rich nations in the Middle East declared an embargo against the United States in retaliation for its support of Israel. The oil embargo had a lasting effect on energy prices.
President Nixon tried to alleviate these problems by devaluing the dollar and declaring wage- and price-freezes.
One more example of how stagflation can hit the economy is when a government prints currency (which would increase the money supply and create inflation), while raising taxes (which would slow economic growth)—resulting in stagflation.
Are we experiencing Stagflation?
Stagflation isn’t common but seems to be the new fashion and hot topic in Europe and other advanced economies.
In 2022, we are seeing a rise in global inflation due to supply side shocks, rising oil prices and supply chains adjusting to Covid and war in Ukraine shocks. However, with high inflation, we are also seeing rapid growth (e.g. UK grew 7.1% in 2021) as it recovered from Covid slump.
However, the economic growth figures are slightly misleading. Most consumers don’t feel there is ‘growth’ of 7.1% because real wages have been squeezed by rising prices. Therefore, it may feel like stagflation to many consumers even its economic stats don’t show classic stagflation.
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