THE HISTORY OF STAGFLATION: A REVIEW OF IRANIAN STAGFLATION by Hossein Salehi, M. Sc. A Thesis In ECONOMICS Submitted to the Graduate Faculty of Texas Tech University in Partial Fulfillment of the Requirements for the Degree of MASTER OF ARTS Approved Dr. Masha Rahnama Chair of Committee Dr. Eleanor Von Ende Dr. Mark Sheridan Dean of the Graduate School August, 2015 Copyright 2015, Hossein Salehi Texas Tech University, Hossein Salehi, August, 2015 ACKNOWLEDGMENTS First and foremost, I wish to thank my wonderful parents who have been endlessly supporting me along the way, and I would like to thank my sister for her unlimited love. Next, I would like to show my deep gratitude to Dr. Masha Rahnama, my thesis advisor, for his patient guidance and encouragement throughout my thesis and graduate studies at Texas Tech University. My sincerest appreciation goes to, Dr. Von Ende, for joining my thesis committee, providing valuable assistance, and devoting her invaluable time to complete this thesis. I also would like to thank Brian Spreng for his positive input and guidance. You all have my sincerest respect. ii Texas Tech University, Hossein Salehi, August, 2015 TABLE OF CONTENTS ACKNOWLEDGMENTS .................................................................................................. ii ABSTRACT ........................................................................................................................ v LIST OF FIGURES ........................................................................................................... vi I. INTRODUCTION .......................................................................................................... 1 1.1. Motivation ............................................................................................................. 1 1.1.1. Keynesian Theory .......................................................................................... 2 1.1.2. Neo-Classical Theory ..................................................................................... 3 1.1.3. Neo-Keynesian Theory .................................................................................. 4 1.1.4. Quantity Theory of Money (Monetarism) ..................................................... 5 1.1.5. Quantity Theories of Stagflation .................................................................... 7 1.1.6. Shock Theory ................................................................................................. 7 1.1.7. Differential Accumulation Theory ................................................................. 7 1.2. Research Objective ............................................................................................... 8 II. LITERATURE REVIEW ............................................................................................ 10 2.1. Aggregate Supply and Aggregate Demand Model (AS/AD model) .................. 10 2.1.1. Supply-Side Model ...................................................................................... 12 2.1.2. Demand-Side Model .................................................................................... 13 2.1.3. Oil Price Shocks ........................................................................................... 14 2.2. Monetary Model .................................................................................................. 16 2.3. Structural Models ................................................................................................ 20 III. HISTORY OF STAGFLATION: CASES AND CURES .......................................... 22 3.1. European Stagflation ........................................................................................... 22 3.2. Latin America: Brazil and Chile ......................................................................... 25 3.3. The Great Stagflation .......................................................................................... 26 iii Texas Tech University, Hossein Salehi, August, 2015 IV. IRAN STAGFLATION .............................................................................................. 34 4.1. History of Iranian Stagflationary Episodes ......................................................... 34 4.2. Oil Shocks ........................................................................................................... 36 4.3. Currency Devaluation ......................................................................................... 37 4.4. Economic Sanctions ............................................................................................ 40 4.5. Economic Mismanagement ................................................................................. 41 V. CONCLUSION ............................................................................................................ 44 References ......................................................................................................................... 46 iv Texas Tech University, Hossein Salehi, August, 2015 ABSTRACT The term “stagflation” was first used by a British politician, Iain Macleod in 1965, to describe the simultaneous occurrence of inflationary period during stagnation. On those days, the United Kingdom was experiencing an inflationary period accompanied by rising unemployment and lack of growth in market demand and business activities. Since then the worldwide economy has faced several stagflationary episodes. This research aims to review the history of stagflation models and theories. Also it tries to investigate the previous stagflation episodes worldwide and their causes. Finally, it will have a special focus on the history of inflation and unemployment in Iran and the occurrence of stagflation in Iran. This study also discusses the possible explanations of current stagflation in the Iranian economy. v Texas Tech University, Hossein Salehi, August, 2015 LIST OF FIGURES 2.1 Oil Price Volatility (1968-2014) ................................................................................ 14 3.1 Unemployment Rate and Inflation in the United States in 1960s ............................... 26 3.2 Unemployment Rate and Inflation in the United States in 1970s – 1980s ............... 27 4.1 The Iranian net oil revenue, percent of GDP (1970 – 2012) ...................................... 37 vi Texas Tech University, Hossein Salehi, August, 2015 CHAPTER I INTRODUCTION 1.1. Motivation Stagflation is relatively a new theoretical term in economics. “Stagflation” (a portmanteau of stagnation and inflation) generally refers to a combination of a persistent and uncomfortably high inflation, steadily high unemployment rate and a slow economic growth rate. Unlike in recession, when the economic output declines and workers lose their jobs, the economy still grows during stagflationary period, just not fast enough to supply jobs for all the job-seekers. Technically speaking, the term “stagflation” has different meanings depending on the factors that are being investigated. Samuelson (1972) offers the weak definition of stagflation as the combination of inflation and unemployment while Parkin and Bade (1986) define the strong version. In their paper, they describe stagflation as the combination of inflation and declining output. Between the weak and strong forms, Baumol et al. (1986) offer the moderate version as the occurrence of inflation during a recessionary period in which the economy demonstrates very slow growth. 1 Texas Tech University, Hossein Salehi, August, 2015 Stagflation can be categorized into two broad types: 1. It is a business-cycle phenomenon that adjusts a prior demand inflation by appearing in the later phase of the cycle. During this phase, the upward trend of real output slows down and even begins to fall. 2. It is an outcome of an upward shift in supply, known as supply inflation, which is not generated by a larger aggregate demand. Because of many opinions about the nature of stagflation, it is a complicated conundrum. In order to understand the theories behind stagflation, it is best to start by discussing the available theories in the field of unemployment and inflation. Once these theories are understood, we can apply them to illustrate the phenomenon of stagflation. 1.1.1. Keynesian Theory The original approach to stagflation was based on unemployment theory which is rooted in the nature of the labor markets and the fact that these do not have market mechanisms. Unlike prices in the goods and services market, wage rates are not regulated by supply and demand. Instead, wages (the price of labor supply) are determined by exogenous factors like institutional variables, rather than by market forces such as excess supply, etc. According to the classical approach, and specifically William Phillips (1958), there is a reverse relationship between inflation and unemployment. This idea was one of the milestones in the development of macroeconomics. In his research, William Phillips 2 Texas Tech University, Hossein Salehi, August, 2015 examined wage inflation and unemployment in the United Kingdom from 1861 to 1957. Phillips found this consistent inverse relationship between unemployment and inflation, so that when unemployment is high, wages increased slowly and vice versa. Prior to the 1970s, Keynesian economists, relying on Phillips reasoning, believed that it is not possible to have both issues, recession and high inflation, together in the economy and they believed the inverse relationship between unemployment and inflation was stable. In other words, Before