Definition of stagflation
Stagflation is a period of rising inflation and falling output. Unemployment is likely to be rising too.
AD / AS diagram showing stagflation (higher price level P1 to P2 and lower real GDP Y1 to Y2)
Causes of stagflation
Stagflation is often caused by a supply side shock. For example, rising commodity prices, such as oil prices, will cause a rise in business costs (transport more expensive) and short run aggregate supply will shift to the left. This causes a higher inflation rate and lower GDP.
People may talk about stagflation if there is a rise in inflation and a fall in the growth rate. This is less damaging than higher inflation and negative growth. But, it still represents a deterioration in the trade off between unemployment and inflation.
Stagflation and Phillips Curve
The traditional Phillips curve suggests there is a trade off between inflation and unemployment. A period of stagflation will shift the Phillips curve to the right, giving a worse trade off.
Phillips curve shifting to the right, indicating stagflation (higher inflation and higher unemployment.
Stagflation in the 1970s
In 1974, we have an inflation spike of 25%, at the same time, we see negative GDP growth. This was caused by the oil price boom and also end of the Barber Boom.
Stagflation in 2010/11
In 2011, the UK experienced a rise in inflation to 5%, at the same time, the economy remained in depression with negative growth / very low growth.
This period of stagflation was caused by:
- Higher oil prices
- Higher food prices
- Impact of devaluation in the value of the Pound increasing import prices.
- Impact of higher taxes, which increased inflation but reduced living standards.
- see also: cost push inflation
Solutions to stagflation
There are no easy solutions to stagflation, though supply side policies to increase productivity may help. Solutions to Stagflation
In 2010/11, the Central Bank decided to keep interest rates low (at 0.5%) because they felt low growth was a bigger problem than some temporary cost-push inflation.