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.
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 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.
- 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.