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What Is Stagflation?

Stagflation is characterized by slow economic growth and relatively high unemployment—or economic stagnation—which is at the same time accompanied by rising prices (i.e. inflation). Stagflation can be alternatively defined as a period of inflation combined with a decline in the gross domestic product (GDP).

KEY TAKEAWAYS

Stagflation refers to an economy that is experiencing a simultaneous increase in inflation and stagnation of economic output.

Stagflation was first recognized during the 1970s when many developed economies experienced rapid inflation and high unemployment as a result of an oil shock.1

The prevailing economic theory at the time could not easily explain how stagflation could occur.

Since the 1970s, rising price levels during periods of slow or negative economic growth have become somewhat of the norm rather than an exceptional situation.

Understanding Stagflation

The term "stagflation" was first used in the 1960s during a time of economic stress in the United Kingdom by politician Iain Macleod while he was speaking in the House of Commons.2 Talking about inflation on one side and stagnation on the other, he called it a "stagnation 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.3 Inflation doubled in 1973 and hit double digits in 1974; unemployment hit 9% by May 1975.45

Stagflation led to the emergence of the misery index. This index, which is the simple sum of the inflation rate and unemployment rate, served as a tool to show just how badly people were feeling when stagflation hit the economy.

Oil Prices

One theory states that stagflation is caused when a sudden increase in the cost of oil reduces an economy's productive capacity. In October 1973, the Organization of Petroleum Exporting Countries (OPEC) issued an embargo against Western countries. This caused the global price of oil to rise dramatically, therefore increasing the costs of goods and contributing to a rise in unemployment.7

Because transportation costs rose, producing products and getting them to shelves became more expensive and prices rose even as people were laid off. Critics of this theory point out that sudden oil price shocks like those of the 1970s did not occur in connection with any of the simultaneous periods of inflation and recession that have occurred since then.8

Poor Economic Policies

Another theory is that the confluence of stagnation and inflation are results of poorly made economic policy. Harsh regulation of markets, goods, and labor in an otherwise inflationary environment are cited as the possible cause of stagflation. Some point to former President Richard Nixon's policies, which may have led to the recession of 1970—a possible precursor to the period of stagflation.

Nixon put tariffs on imports and froze wages and prices for 90 days, to prevent prices from rising.9 The sudden economic shock of oil shortages and rapid acceleration of prices once the controls were relaxed led to economic chaos.

While appealing, like the previous theory, this is an ad-hoc explanation of the stagflation of the 1970s, which does not explain the simultaneous rise in prices and unemployment that has accompanied subsequent recessions up to the present.

The Gold Standard

Other theories point to monetary factors that may also play a role in stagflation. Nixon removed the last indirect vestiges of the gold standard and brought down the Bretton Woods system of international finance.10

This removed commodity backing for the currency and put the U.S. dollar and most other world currencies on a fiat basis ever since then, ending most practical constraints on monetary expansion and currency devaluation.

What Causes Stagflation?

Stagflation is characterized by slow economic growth and relatively high unemployment—or economic stagnation—which is at the same time accompanied by rising prices (i.e. inflation). Generally, stagflation occurs when the money supply is expanding while supply is being constrained.

Why Is Stagflation Bad?

Stagflation is a contradiction as slow economic growth would likely lead to an increase in unemployment but should not result in rising prices. This is why this phenomenon is considered bad—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 is in decline.

What Is the Cure for Stagflation?

There is no definitive cure for stagflation. 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 (that is easier said than done, so the key to preventing stagflation is to be extremely proactive in avoiding it).

What Is an Example of Stagflation?

An example of stagflation 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.

source: https://www.investopedia.com/terms/s/stagflation.asp

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