Stagflation is a condition in which an economy experiences a combination of stagnant economic growth, high unemployment, and high inflation. Stagflation is a rare and often challenging economic phenomenon because it presents policymakers with a tough trade-off between stimulating economic growth and controlling inflation.
In traditional economic theory, inflation and unemployment are thought to have an inverse relationship, which means that when unemployment is low, inflation should be high, and vice versa. However, in stagflation, inflation and economic stagnation co-occur, which creates an unusual situation where traditional policy tools may be ineffective.
Stagflation can occur due to a variety of factors, including supply shocks such as sudden increases in the price of oil or other essential commodities, excessive government spending, or a lack of productivity growth. It can be challenging to address because traditional economic policy tools, such as reducing interest rates, may not be effective in this context.
Stagflation is an undesirable economic outcome because it can lead to declining living standards, rising unemployment, and increased uncertainty for businesses and households.
Causes of stagflation
- Supply-side shocks: These include sudden increases in the price of essential commodities, such as oil, food, or other raw materials, that are used in the production process. These price increases lead to higher production costs and reduce the supply of goods and services, causing both inflation and reduced economic growth.
- Structural factors: These include problems with the structure of the economy, such as a lack of productivity growth or inefficiencies in the labour market, which can lead to higher costs and reduced economic growth.
- Demand-side shocks: These include sudden changes in demand for goods and services, such as a sudden drop in consumer spending, which can lead to both higher unemployment and reduced economic growth.
- Policy mistakes: These include policy decisions that lead to unintended consequences, such as an overly expansionary monetary policy that leads to higher inflation, or an overly contractionary fiscal policy that leads to reduced economic growth.
It’s worth noting that the causes of stagflation are often interconnected, and it can be challenging to identify a single root cause. For example, a supply-side shock such as a sudden increase in oil prices can lead to both higher inflation and reduced economic growth, while at the same time exposing structural problems in the economy that were previously hidden. Similarly, policy mistakes can exacerbate existing economic problems, leading to a cycle of stagflation that is difficult to break.
Measures to end stagflation
- Tightening monetary policy: One way to combat inflation is to raise interest rates, which can reduce consumer spending and investment, thereby reducing demand-pull inflation. However, tightening monetary policy can also lead to higher unemployment and reduced economic growth, exacerbating stagflation. As such, central banks must balance the need to combat inflation with the need to support economic growth.
- Stimulating demand: In some cases, stagflation can be caused by a lack of demand for goods and services, leading to both inflation and reduced economic growth. If so, fiscal stimulus, such as tax cuts or government spending, can help stimulate demand and boost economic growth.
- Addressing structural issues: Addressing underlying structural problems in the economy, such as improving labour market efficiency or investing in new technologies, can help increase productivity and reduce costs, which can combat stagflation.
- Supply-side policies: Policies aimed at increasing the supply of goods and services, such as deregulation, investment in infrastructure, or incentives for businesses to invest in new technologies, can also help combat stagflation by increasing production and reducing costs.
- Addressing external factors: In some cases, stagflation can be caused by external factors, such as sudden increases in the price of essential commodities. Addressing these external factors may require international cooperation or the development of new supply chains and markets.
How long does stagflation last?
The duration of stagflation can vary depending on the underlying causes of the phenomenon and the policy responses implemented to address it. In some cases, stagflation can be relatively short-lived, while in others, it can persist for several years.
For example, in the United States in the 1970s, stagflation persisted for nearly a decade, from the mid-1970s to the early 1980s. During this period, the economy experienced a combination of high inflation and high unemployment, which persisted despite various policy responses aimed at addressing the problem.
On the other hand, stagflation caused by a temporary supply-side shock, such as a sudden increase in the price of oil, may be relatively short-lived and resolve itself as supply and demand adjust to the new conditions.
Ultimately, the duration of stagflation will depend on a range of factors, including the underlying causes of the phenomenon, the effectiveness of policy responses, and the resilience of the economy to adapt and adjust to changing conditions.
History of stagflation
Stagflation is a relatively rare phenomenon in economic history, and its occurrence is generally associated with periods of significant economic disruption or policy mistakes.
The term “stagflation” was first coined in the 1960s in the United Kingdom to describe the unusual combination of high unemployment and inflation that was occurring in that developed country at the time. Prior to this period, it was widely believed that inflation and unemployment had an inverse relationship — that is, when unemployment was high, inflation would be low, and vice versa.
The primary cause of stagflation in the 1970s in some developed countries, including the United States, the United Kingdom, and Australia, was a series of supply shocks, including sudden increases in the price of oil and other essential commodities. These supply shocks were mainly due to the OPEC oil embargo in 1973 and the Iranian Revolution in 1979. These supply shocks caused prices to rise, leading to inflation, while at the same time reducing economic growth and causing unemployment to increase. At the same time, rising inflation made it difficult for policymakers to stimulate the economy through the conventional monetary policy tools, such as lowering interest rates. During this time, Australia also faced several other economic challenges, such as high public debt levels and a significant balance of payments deficit.
Since the 1970s, there have been relatively few occurrences of stagflation in developed countries, although there have been some notable occurrences in other countries, such as the 2010s economic crisis in Venezuela.
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