Solution to Stagflation

Readers Question: what is the solution for stagflation?

Stagflation occurs when there is an increase in inflation and an increase in unemployment and lower growth.

Typically stagflation will be caused by an increase in the cost of production which shifts the AS curve to the left.

Diagram of Stagflation

The diagram shows that the stagflation causes the price level to rise from P1 to P2. Output falls from Y1 to Y2

How To Solve Stagflation?

It is not easy. For example You could use Monetary policy to reduce inflation. Higher Interest rates increase the cost of borrowing and will reduce AD. This will be effective for reducing inflation, but, it will cause a  bigger fall in GDP.

If the MPC cut interest rates they may increase GDP, but would  make inflation worse.  Therefore demand side policies cannot solve stagflation they can only solve one particular aspect.

The only solution to stagflation is to increase AS through supply side policies. However, these will take a long time. Also if the cost push inflation occurs because of a global increase in the price of oil and food, there is little that the UK government can do about it. There are concerns about stagflation in the UK but a solution is not easy. However, often cost push inflation is a temporary affair e.g. rising energy prices may not continue for ever (hopefully)