Stagflation

Definition of stagflation

Stagflation is a period of rising inflation but  falling output and rising unemployment

Stagflation is often caused by a rise in the price of commodities, such as oil. Stagflation occurred in the 1970s following the tripling in the price of oil.

A degree of stagflation occurred in 2008, following the rise in the price of oil and start of the global recession.

Diagram stagflation

SRAS-shift-leftHigher oil prices increase costs of firms causing SRAS to shift to the left.
AD/AS diagram showing stagflation (higher price level P1 to P2 and lower real GDP Y1 to Y2)

Causes of stagflation

  • Oil price rise 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.
  • Powerful trade unions. If trade unions have strong bargaining power – they may be able to bargain for higher wages, even in periods of lower economic growth. Higher wages are a significant cause of inflation.
  • Falling productivity. If an economy experiences falling productivity – workers becoming more inefficient; costs will rise and output fall.
  • Rise in structural unemployment. If there is a decline in traditional industries, we may get more structural unemployment and lower output. Thus we can get higher unemployment – even if inflation is also increasing.

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-shift-right

Phillips curve shifting to the right, indicating stagflation (higher inflation and higher unemployment.

Stagflation in the 1970s

stagflation

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.

econ-growth-inflation-dec-2011png

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.

  • Monetary policy can generally try to reduce inflation (higher interest rates) or increase economic growth (cut interest rates). Monetary policy cannot solve both inflation and recession at the same time.
  • One solution 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.
  • The only real solution is supply-side policies to increase productivity, this enables higher growth without inflation. See: 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.

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