What is Stagflation?
Stagflation is a phenomenon that occurs when the economy experiences both inflation and stagnation at the same time. It is an economic condition wherein there is a rise in prices without any corresponding increase in production or employment. Stagflation is a relatively new concept that was first observed during the 1970s. The term was created by combining two words – stagnation (a period of slow or non-existent economic activity) and inflation (a rise in prices).
Stagflation occurs when there is a lack of demand in the economy and an increase in prices. The two things that contribute to this are supply-side factors or demand-side factors. Supply-side factors would include an increase in oil prices or an increase in wages without a corresponding increase in productivity. Demand-side factors would include decreased consumer spending on goods or services because of higher interest rates or increased trade tariffs on goods imported from outside.
Generally, there are three economic components that indicate a stagflation situation: Rising Inflation, Rising Unemployment and Declining demand for goods and services.
What causes Stagflation ?
There are three economic components that indicate a stagflation situation: Rising Inflation, Rising Unemployment and Declining demand for goods and services. Such situation in economy can happen:
- A decrease in aggregate demand
- High taxes or other barriers to demand
- A decline in foreign trade
- Inadequate investment in new technologies
- A decline in worker productivity
- An increase in the price of land, natural resources or energy
All these above mentioned situations are the result of supply shock and poor economic policies. The supply shock theory suggests that iT occurs when an economy faces a sudden increase or decrease in the supply of a commodity or service due to various other reasons like rise in oil price, change in tariffs etc. Poorly made economic policies is another reason for stagflation. Poorly made policies affect the market condition impacting the disruption in product/service, labor and money market causing such phenomenon.
Stagflation of 1970s in the United States
In the 1970s, the United States experienced stagflation. This was a period in which inflation and unemployment rates were both high at the same time. Economists have been debating about what caused this period of high inflation and unemployment rates for decades. There are many different theories as to what caused this period of stagflation. The three most popular theories as to what caused this stagflation are:
- High oil prices
- The Nixon Shock
- The Federal Reserve’s tight monetary policy.
High oil prices caused stagflation in the United States. This theory can be found in the book “The Oil Crisis” by Charles E. Lindblom, who explains that high oil prices increase costs for goods and services, which leads to inflationary pressures on wages and prices. In this period of stagflation, there was a shortage of goods because the demand for oil was mostly used for making goods, so the price of goods went up.
Another theory is that the Nixon Shock caused stagflation. This theory can be found in “Monetary Policy, Business Cycles and Sustained Growth” by Milton Friedman and Anna Schwartz. In this period of stagflation, there was a surplus in the US money supply because President Richard Nixon closed the gold window and put an end to the Bretton Woods system. This, in turn, caused a rise in prices as not enough money was being injected into the economy.