Stagflation can define an economy experiencing a combination of slow economic growth and relatively high unemployment. An economy failing to generate an environment conducive to investment will face multifaceted macroeconomic challenges. Stagflation has real consequences for consumers, such as rising prices. The economy is often at risk of descending into a recession during Stagflation. This problem is due to the gross domestic product (GDP) decline. Fewer goods and services being produced will lead to less money flowing through the hands of consumers to spend. The simultaneous increase in inflation and stagnation of economic activities last happened in the U.S. in the 1970s. It took nearly 15 years for the U.S. to recover from Stagflation fully. Many economic theorists at the time struggled to explain how the stagflation phenomenon could occur quickly. Historical cases have shown that rising price levels can occur during periods of negative economic growth. It is pretty standard and is not an exceptional situation.
What Causes Stagflation?
Supply Shocks
Stagflation can occur when a sudden bottleneck exists in an entire economic sector. An increase in the cost of oil is one of the most common types of shocks. Oil costing more to the economy reduces its productive capacity. The American economy was last affected by this problem in October 1973. A group of countries in the Middle East moved to place an oil embargo on the U.S. as a way to sanction them. The Organization of Petroleum Exporting Countries (OPEC) sanctioned several Western countries for their role in protecting Israel. As a result, the global price of oil rose dramatically. It made Western goods and services more expensive therefore taking away their international competitiveness. When an economy is less competitive, it causes unemployment and a drop in production. Fuel is directly linked to transportation costs, pushing up the cost of goods for customers..Prices begin to soar even though jobs are being lost in the economy.
Poor Monetary & Fiscal Policies
Economic stagnation and inflation can occur due to poorly timed monetary policy. The government harshly regulates markets, goods, and labor, which can cause an inflationary environment. During the 1970s, former President Richard Nixon’s policies are believed to have caused long-term Stagflation in exchange for some temporary relief. President Nixon introduced tariffs on imports and froze wages. The measures were meant to last for 90 days and were introduced to curb inflation. Consumers being introduced to sudden economic shocks from oil scarcity led to less spending.
The Gold Standard
President Nixon removed this economic benchmark to bring down the Bretton Woods international finance system. The currency could no longer store value as it did in the past. A currency not backed by a commodity placed the dollar on a fiat basis. The money went into free fall and led to currency devaluation. The introduction of this policy caused most practical constraints on monetary expansion.
Does inflation cause Stagflation?
Inflation is one of the monetary explanations used to describe periods of Stagflation. Economists argue that the gold standard America used was best for storing value. The countervailing historical record shows the economy delivered simultaneously decreasing prices and low unemployment because of the solid commodity-backed currency system. When the currency was unbacked, it turned to a fiat monetary system. Inflation is often a prelude to Stagflation as there is assumed to be a stable relationship between inflation and unemployment. The correlation works on the grounds of consumer and producer expectations. If society expects inflation rates to be high, people will change their economic behavior. The perceived future inflation rate means people will adjust their rates to accommodate rising prices. The behavior is in reaction to monetary policy changes.
Consumers worrying about prices rising throughout the economy leads to expansionary monetary policy. If there is no corresponding decrease in unemployment, the economy is choked with increasing unemployment rates based on the economic shocks affecting the economy. Recessions are often not associated with high inflation levels, meaning there is little effect on promoting real economic growth, which helps to recover from Stagflation. For the Federal Reserve to fix the economy, it will attempt to stimulate GDP to match inflation rates.
Why Is Stagflation Bad?
Stagflation goes against the stable relationship between slow economic growth and high inflation compounded by increased unemployment. Rising prices are a common feature of this phenomenon. Given the high unemployment, the consumers in the economy have decreased consumer spending power. The less disposable income consumers have, the harder it is for them to handle high inflation. The citizens who keep their savings in cash will soon realize the significant loss of value during Stagflation.
What Is the Cure for Stagflation?
Stagflation will take time to recover from. Economists have not found a definitive method to deal with Stagflation quickly. At this time, the depressing nature of the economy means productivity needs to be increased. To generate confidence amongst consumers, the economy needs to spend money. Investment generation is key to leading to higher growth without additional inflation. The Federal Reserve can then begin to tighten monetary policy and reduce inflation. When the amount of goods available to match the money supply is evenly balanced, the consumers will rein in the inflation component of Stagflation. It took the U.S. close to 15 years to recover from its Stagflation in the 1970s.
