Stagflation:
Stagflation is the economic condition in which there is extremely slow economic growth and high unemployment (stagnation) accompanied by high inflation. The word itself is a portmanteau of the two words stagnation and inflation. It is a tricky situation to be in because policy measures to counter one condition could further aggravate the other – measures to stimulate growth could further raise inflation levels and measures to control inflation could further slow economic growth.
Causes:
Economists commonly state two possible causes for stagflation:
1. When the productive capacity of an economy is sharply reduced due to an unfavourable supply shock – such as a sharp increase in oil prices. This leads to both an increase in prices and a decrease in production since production is now more costly and less profitable. Hence prices rise while the economy is slowing down.
2. Conflicting macroeconomic policies – For example when the central banks allow a rapid increase in money supply by keeping interest rates low while the government causes stagnation by rigid regulation of the goods markets and/or the labour markets. Strict regulation limits economic growth while the growth in money supply drives up demand and hence prices.
The U.S. Stagflation of the 1970’s:
From 1958 to 1973, USA experienced the "Post-War Boom". The economy grew by an average of 5% annually, fuelling a slow but steady rise in prices. In this period, the Federal Reserve's monetary policy was guided by diehard Keynesians who believed in the Phillips Curve which gives the relationship between unemployment and inflation. The Fed believed that the inverse relationship between unemployment and inflation was stable and decided to use its monetary policy to increase overall demand and keep unemployment low. They believed the only trade-off would be a safely rising inflation rate.
However, the unnaturally low unemployment in the 1960s caused a wage-price spiral. The government poured money into the economy to increase demand, making prices rise. Workers, noting the rise in prices, expected their wages to rise accordingly. For a while, employers were willing to raise wages, but then inflation began to rise faster than wages. Workers weren't willing to supply labour for lower wages, so unemployment increased even as inflation continued to rise. Industry faced a scarcity of labour and the growth was slowing.
The real kicker for stagflation came in with the OPEC’s oil embargo of 1973, which brought oil prices to record new levels. Prices skyrocketed across all U.S. industries. In 1970, inflation was 5.5 percent. By 1974, it was 12.2 percent, and then it peaked at a crippling 13.3 percent in 1979. The stock market ground to a halt. The annual return on bonds dropped below inflation levels.
Further reading: http://www.businessbookmall.com/Economics_16_Stagflation_and_the_Rise_of_Supply-Side_Economics.htm
Stagflation is the economic condition in which there is extremely slow economic growth and high unemployment (stagnation) accompanied by high inflation. The word itself is a portmanteau of the two words stagnation and inflation. It is a tricky situation to be in because policy measures to counter one condition could further aggravate the other – measures to stimulate growth could further raise inflation levels and measures to control inflation could further slow economic growth.
Causes:
Economists commonly state two possible causes for stagflation:
1. When the productive capacity of an economy is sharply reduced due to an unfavourable supply shock – such as a sharp increase in oil prices. This leads to both an increase in prices and a decrease in production since production is now more costly and less profitable. Hence prices rise while the economy is slowing down.
2. Conflicting macroeconomic policies – For example when the central banks allow a rapid increase in money supply by keeping interest rates low while the government causes stagnation by rigid regulation of the goods markets and/or the labour markets. Strict regulation limits economic growth while the growth in money supply drives up demand and hence prices.
The U.S. Stagflation of the 1970’s:
From 1958 to 1973, USA experienced the "Post-War Boom". The economy grew by an average of 5% annually, fuelling a slow but steady rise in prices. In this period, the Federal Reserve's monetary policy was guided by diehard Keynesians who believed in the Phillips Curve which gives the relationship between unemployment and inflation. The Fed believed that the inverse relationship between unemployment and inflation was stable and decided to use its monetary policy to increase overall demand and keep unemployment low. They believed the only trade-off would be a safely rising inflation rate.
However, the unnaturally low unemployment in the 1960s caused a wage-price spiral. The government poured money into the economy to increase demand, making prices rise. Workers, noting the rise in prices, expected their wages to rise accordingly. For a while, employers were willing to raise wages, but then inflation began to rise faster than wages. Workers weren't willing to supply labour for lower wages, so unemployment increased even as inflation continued to rise. Industry faced a scarcity of labour and the growth was slowing.
The real kicker for stagflation came in with the OPEC’s oil embargo of 1973, which brought oil prices to record new levels. Prices skyrocketed across all U.S. industries. In 1970, inflation was 5.5 percent. By 1974, it was 12.2 percent, and then it peaked at a crippling 13.3 percent in 1979. The stock market ground to a halt. The annual return on bonds dropped below inflation levels.
Further reading: http://www.businessbookmall.com/Economics_16_Stagflation_and_the_Rise_of_Supply-Side_Economics.htm
