What is stagflation?

Given the situation many economies around the world find themselves in right now, the term “stagflation” is one you’re likely to come across often when researching the markets and investment strategies. Stagflation describes a period of time during which slow economic growth, a high rate of unemployment, and rising inflation are all experienced at once.

In this AAG Academy guide, we’ll explain in detail what stagflation means, what causes it, and whether you should be worried about it. We’ll also look at how stagflation compares to standard inflation from an economic perspective.

The term stagflation comes from an amalgamation of the words stagnation and inflation. It is believed one of the first uses of the term came in 1965, when Iain Macleod, a British Conservative Party politician, said in a speech, “We now have the worst of both worlds — not just inflation on the one side or stagnation on the other, but both of them together.”

“We have a sort of ‘stagflation’ situation and history in modern terms is indeed being made,” Macleod continued. Prior to this, few economists believed that stagflation was possible since the rate of unemployment and the rate of inflation typically move in opposite directions. However, the “Great Inflation” period of the 1970s proved that was not always the case.

Over the years, stagflation has become an increasingly popular term for describing an economic condition in which stagnation and inflation are experienced simultaneously. Fortunately, it remains a relatively rare occurrence, but as economic growth stalls around the world and inflation continues to rise, another period of stagflation is becoming a real concern.

What causes stagflation?

In the same way that many different scenarios can lead to a higher rate of unemployment or a rise in inflation, there are lots of things that can lead to a period of stagflation. However, economists believe that there are two key principles for why stagflation occurs:

Supply shock
One of those principals is what is referred to as supply shock, which is when a key commodity like oil sees a rapid price increase. Not only do prices rise, but economic growth slows because production becomes more costly and less profitable.

Government
Certain government decisions, such as introducing policies that harm industry while increasing the money supply too quickly, are the second key principal. These two things have to occur simultaneously since one without the other would only cause stagnation or inflation.

Why is stagflation bad?

Stagflation is considered bad because it combines three negatives that all occur simultaneously. As we mentioned above, stagnation and inflation are usually experienced independently. The Phillips curve, an economic model developed by William Phillips in 1958, suggested that inflation and unemployment have a stable and inverse relationship.

In other words, when inflation rises, unemployment falls, and vice-versa. Phillips wasn’t completely wrong, since that’s exactly what has happened in most cases throughout history. And it means that, usually, we have a positive with a negative. However, when stagflation occurs, that inverse relationship between inflation and unemployment breaks down.

Stagflation sees the rate of unemployment rise and an increase in inflation at the same time, and therefore slow economic growth. There are no positives that we can take comfort from.

Stagflation vs. inflation

We see inflation when there is a sustained increase in the average price of almost all goods and services, not just a few of them. It is most obvious when you end up having to spend more on things like groceries, gas, energy, and water at the same time — even though your consumption, or how much you’re buying, has not changed.

It is important to bear in mind that while inflation is an important part of stagflation, they are two different things. As we have outlined above, inflation can occur independently — while employment rates are falling — and therefore a rise in prices doesn’t necessarily mean we are experiencing a stagflation.

Can stagflation be avoided?

It is incredibly difficult for stagflation to be avoided once an economy is headed in that direction. Furthermore, a fix would typically require multiple policymakers to roll out the right decisions at the same time. For instance, a central bank can increase interest rates to reduce inflation, but it cannot also fix rising unemployment.

By the time we can see a stagflation on the horizon, it is usually too late to reverse it. However, a stagflation can be minimized and reduced in length with a lot of hard work. Economists believe that the best way to get out of a stagflation is to increase productivity to the point where we increase growth without additional inflation.

References

• What is stagflation and what does it mean for the future economy
• What is stagflation
• What is stagflation
• Stagflation
• Phillipscurve
• Stagflation