Stagflation

Definition of stagflation

  • Stagflation is a period of rising inflation but falling output and rising unemployment.
  • Stagflaton is often a period of falling real incomes as wages struggle to keep up with rising prices.
  • 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 the start of the global recession.
  • Stagflation is difficult for policy makers. 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.

Video on stagflation

Diagram stagflation

SRAS-shift-left Higher 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.
  • Supply shocks. If there is disruption to supply chains, there prices will start rising. The supply shock will also cause decrease in unemployment. For example, in 2021, UK supply shocks caused moderate degree of stagflation.

Moderate stagflation

People may talk about stagflation if there is a rise in inflation and a fall in the growth rate (i.e. the economy is growing at a slower 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

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.

phillips-curve-breakdown

This shows how in the 1970s, the US economy faced a worse trade off- there was higher inflation and higher unemployment. The Phillips Curve was shifting to the right.

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 on 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.

Misery index

The misery index is a measure of unemployment + inflation. Stagflation leads to rise in both unemployment and inflation so a high misery index indicates a period of stagflation. This shows in 2012, the UK experienced a misery index of nearly 14% due to high unemployment and inflation.

misery-index-2021

Stagflation of the 1970s

us-inflation-1948-2021 copy In the 1970s, the US experienced a sharp rise in inflation due to the pressure of rising oil prices.

us-unemployment-1948-2021

The inflation also led to rising unemployment as the post-war economic boom stalled.

The stagflation was an important turning point for a few reasons.

  • The post-war Keynesian consensus was challenged. Until the 1970s, it seemed the government and Federal Reserve could manage the economic cycle. But, the 1970s, saw a rise in both unemployment and inflation and it appeared traditional fiscal and monetary policy were unable to solve the twin problems.
  • The economic problems of the 1970s, allowed monetarists like Milton Friedman to become more dominant and in the early 1980s, the UK and US introduced monetarist policies seeking to tackle inflation as primary goal and ignore short-term costs of unemployment.

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