An economic situation in which there is continuing inflation in spite of depressed economic conditions and high unemployment. Prior to the 1970s economists had thought that while inflation and stagnation were both unpleasant, they were at least alternatives; after the 19734 oil crisis they discovered that inflation and stagnation could coexist. This was very embarrassing for believers in demand management, as raising demand might worsen inflation while cutting demand would worsen unemployment. Supply-side economists would argue that this showed how necessary their policies were.
Stagflation, a combination of the words stagnation and inflation, is a term in macroeconomics used to describe a period of high price inflation combined with slow output growth, high unemployment, or recession.
Stagflation is a problem because most tools for directing the economy, that is fiscal policy and monetary policy can trade off growth for inflation. The other choice is to pursue a tight monetary policy (reducting government debt purchases in order to raise interest rates) to reduce inflation, probably at the cost higher unemployment and slower output growth. Unless there is a differential impact on either revenues or spending due to stagflation, the impact of stagflation on the budget balance is not altogether clear. As a policy matter, there is one school of thought that the best policy mix is one in which government stimulates growth through increased spending or reduced taxes while the central bank fights inflation through higher interest rates.
Theories of stagflation
Neo-classical theory
In neo-classical economic theory, stagflation is rooted in the failure of the overall market to allocate goods and services efficiently.
Shock theory
One set of theories argue that stagflation occurs because of outside forces to an economy or "exogenous" factors. In this view stagflation is thought to occur when there is an adverse shock (a sudden increase, for example in the price of oil), in a country's aggregate supply curve.
Quality of money theories
Modern monetary economics assumes that a crucial role for central banks in maintaining stable prices is management of inflationary expectations. If central banks are seen to pursue growth at the cost of higher inflation, economic factors may conclude that the central bank will continue to allow high inflation, and so demand higher prices for their products and higher wages for their labor.
Quantity theories of stagflation
Quantity theories of inflation, such as monetarism, argue that inflation is due to the money supply rather than demand and predict that inflation can occur with high unemployment if the government increases the money supply in a period of rising prices.
Classical Keynesianism and the Phillips curve
In the 1960s it was thought that the Phillips curve, which was associated with Keynesian economics suggested that stagflation is impossible because high unemployment lowers demand for goods and services which lowers prices. However, in the 1970s and 1980s, when actual stagflation occurred, it was realized that the relationship between inflation and employment levels was not a constant, but could be shifted, and that the Phillips relationship was better seen through payroll surveys (Current Employment Statistics) of employment rather than household surveys (Current Population Survey) ().
Neo-Keynesianism
Neo-Keynesian theory developed a more detailed model of inflation which argued that there are two kinds of inflation - wage pull and cost push. Stagflation, in this view, is caused by cost push inflation, which could be the result of monetary policy, insufficient resiliency of the economy or from purely external factors. In this case the strategy for defeating stagflation is to cut the money supply, hoping to cut inflation to manageable levels, then increase the money supply to spur economic growth.
Historical stagflation
Stagflation in the late Classical Keynesian Period (1968-1982)
Stagflation occurred in the economies of the United Kingdom in the 1960s and 1970s and the United States during the 1970s, most famously during the Carter Administration. The pendulum has, to some extent, swung back in the other direction as monetarism has seemed to encounter increasing difficulty predicting the demand for money and the long period of low inflation and high employment during the Y2K/dotcom bubble of the late 1990s and again during the 2004-2006 period, which temporarily drove oil prices high enough to measureably increase inflation during the first three quarters of 2006.
Stagflation worries in the present
During 2006, certain economists believed that global stagflation might return when the price of oil was close to $80 a barrel, and the US Federal Reserve was increasing interest rates.
Responses to stagflation
Stagflation undermined the dominant Keynesian consensus, and placed renewed emphasis on microeconomic behavior, particulary neo-classical economics with its attempt to root macroeconomics in microeconomic formalisms. The rise of conservative theories of economics, including monetarism, can be traced to the failure, or perceived failure, of Keynesian policies to combat stagflation, or even properly explain it.
Stagflation in the USA was defeated by the then Federal Reserve chairman, Paul Volcker, who sharply increased interest rates to reduce money supply from 1979-1983 in what was called a "disinflationary scenario."
Supply-side economics emerged as a response to US stagflation in the 1970s.
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