Definition of stagflation
Stagflation is a period of rising inflation and falling output. Unemployment is likely to be rising too.
In economics, stagflation, a portmanteau of stagnation and inflation, is a situation in which the inflation rate is high, the economic growth rate slows, and unemployment remains steadily high. It raises a dilemma for economic policy, since actions designed to lower inflation may exacerbate unemployment, and vice versa.
Diagram stagflation
Keynes did not use the term, but some of his work refers to the conditions that most would recognise as stagflation. In the version of Keynesian macroeconomic theory that was dominant between the end of World War II and the late 1970s, inflation and recession were regarded as mutually exclusive, the relationship between the two being described by thePhillips curve. Stagflation is very costly and difficult to eradicate once it starts, both in social terms and in budget deficits. One economic indicator, the misery index, is derived by the simple addition of the inflation rate to the unemployment rate.
Demand-pull stagflation theory[edit]
Demand-pull stagflation theory explores the idea that stagflation can result exclusively from monetary shocks without any concurrent supply shocks or negative shifts in economic output potential. Demand-pull theory describes a scenario where stagflation can occur following a period of monetary policy implementations that cause inflation. This theory was first proposed in 1999 by Eduardo Loyo of Harvard University's John F. Kennedy School of Government.[28]
Supply-side theory:
Supply-side economics emerged as a response to US stagflation in the 1970s. It largely attributed inflation to the ending of the Bretton Woods system in 1971 and the lack of a specific price reference in the subsequent monetary policies (Keynesian and Monetarism). Supply-side economists asserted that the contraction component of stagflation resulted from an inflation-induced rise in real tax rates.
Jane Jacobs and the influence of cities on stagflation:
In 1984, journalist and activist Jane Jacobs proposed the failure of major macroeconomic theories to explain stagflation was due to their focus on the nation as the salient unit of economic analysis, rather than the city. She proposed the key to avoiding stagflation was for a nation to focus on the development of "import-replacing cities", which would experience economic ups and downs at different times, providing overall national stability and avoiding widespread stagflation. According to Jacobs, import-replacing cities are those which have developed economies balancing their own production with domestic imports, meaning they can respond with flexibility as economic supply and demand cycles change over time. While lauding her originality, clarity, and consistency, urban planning scholars have criticized Jacobs for not comparing her own ideas to those of major theorists (e.g., Adam Smith, Karl Marx) with the same depth and breadth they developed, as well as a lack of scholarly documentation. Despite these issues, Jacobs' work is notable for having widespread public readership and influence on decision-makers. Responses:
Stagflation undermined support for Keynesian consensus. The rise of conservative theories of economics, including monetarism, can be traced to the failure of Keynesian policies to combat stagflation or explain it to the satisfaction of economists and policy-makers.
Federal Reserve chairman Paul Volcker very sharply increased interest rates from 1979–1983 in what was called a "disinflationary scenario." After U.S. prime interest rates had soared into the double-digits, inflation did come down; these interest rates were the highest long-term prime interest rates that had ever existed in modern capital markets. Volcker is often credited with having stopped at least the inflationary side of stagflation, although the American economy also dipped into recession. Starting in approximately 1983, growth began a recovery. Both fiscal stimulus and money supply growth were policy at this time. A five- to six-year jump in unemployment during the Volcker disinflation suggests Volcker may have trusted unemployment to self-correct and return to its natural rate within a reasonable period.
Explaining the 1970s stagflation:
Following Richard Nixon's imposition of wage and price controls on 15 August 1971, an initial wave of cost-push shocks in commodities were blamed for causing spiraling prices. Perhaps the most notorious factor cited at that time was the failure of the Peruvian anchovy fishery in 1972, a major source of livestock feed. The second major shock was the 1973 oil crisis, when the Organization of Petroleum Exporting Countries (OPEC) constrained the worldwide supply of oil. Both events, combined with the overall energy shortage that characterized the 1970s, resulted in actual or relative scarcity of raw materials. The price controls resulted in shortages at the point of purchase, causing, for example, queues of consumers at fuelling stations and increased production costs for industry.
By Lisa SmithAAA |
Stagflation is an economic phenomenon marked by slow economic growth and rising prices. In the 1970s, the phenomenon hit hard, as rising inflation and slumping employment put a damper on economic growth. As a result, for investors in equity markets, "stagflation" can be a hard word to hear. In this article, we'll take a look at how stagflation is measured, what factors contribute to it and how to protect your finances. (For background reading, check outStagflation, 1970s Style.) Recent views[edit]
Through the mid-1970s, none of the major macroeconomic models (Keynesian, New Classical, and monetarist) were able to explain stagflation.
After several years of research, a convincing explanation was provided based on the effects of adverse supply shocks on both prices and output. According to Blanchard (2009), these adverse events were one of two components of stagflation; the other was "ideas", which Robert Lucas (famous for the Lucas Supply Curve),Thomas Sargent, and Robert Barro were cited as expressing as "wildly incorrect" and "fundamentally flawed" predictions [of Keynesian economics] which, they said, left stagflation to be explained by "contemporary students of the business cycle".
Causes of stagflation
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.
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.
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, though supply side policies to increase productivity may help. 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.