Stagflation

Stagflation is a macroeconomics term used to describe a period of inflation combined with stagnation (that is, slow economic growth and rising unemployment, possibly including recession).

Stagflation came to be recognized as a potentially important macroeconomic problem in the 1970s, when it afflicted many countries in the developed and developing world. Prior to the 1970s, the prevailing Keynesian school of macroeconomics assumed that inflation and stagnation were unlikely to occur together. Macroeconomists at that time believed that stagnation could typically be cured by expansionary monetary or fiscal policies, while inflation could be cured by contractionary monetary or fiscal policies. When both stagnation and inflation occurred at the same time, this called into question existing macroeconomic theories and also posed a dilemma for the standard policy remedies that had been used to stabilize the economy in the past.

Economists today typically offer two main explanations of stagflation. First, stagflation can occur when an economy is slowed by an unfavorable supply shock, such as an increase in the price of oil in an oil importing country, which tends to raise prices at the same time that it slows the economy by making production less profitable.[5] Second, both stagnation (recession) and inflation can be caused by inappropriate macroeconomic policies. For example, central banks can cause inflation by permitting excessive growth of the money supply, and the government can cause stagnation by excessive regulation of goods markets and labor markets.

Stagflation becomes a dilemma for monetary policy when policies usually used to increase economic growth will further increase runaway inflation while policies used to fight inflation will further the decline of an already-declining economy.

An important monetary mechanism to increase economic growth is by lowering interest rates, which reduces the cost for consumers to buy products on credit and businesses to borrow to expand production. While this can increase economic activity, it can also result in increased inflation. The monetary mechanism to reduce inflation is by raising interest rates, which increases the cost for consumers to buy products on credit and businesses to borrow to expand production. While this can reduce inflation, it can also result in decreased economic activity.

Stagflation becomes a problem only when the impact of the further use of the principal monetary policy tool available to assist central bank direction of the domestic economy does more marginal harm than marginal good, if used. Ultimately, the central bank can either stimulate the economy or attempt to rein it in through the mechanism of adjusting the domestic interest rate, its primary tool.

A choice can be implemented that tends to improve growth, but does it ignite systemic inflation? A choice can be implemented that tends to fight inflation, but how badly does it impinge growth? During periods properly described as stagflation both problems co-exist. In modern times, it will be only after the central bank has used all possible tools to meet both goals, using the best quantitative measures it has at its disposal, for stagflation to occur. Major economic conditions of unusual proportion will have already created near-crises on both fronts before stagflation can set in again. Stagflation is the name of the dilemma that exists when the central bank has rendered itself powerless to fix either inflation or stagnation.

The problem for fiscal policy is far less clear. Both revenues and expenditures tend to rise with inflation, and with balanced budget politics, they fall as growth slows. 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. One school of thought is 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. Whatever theory is employed, coordinating fiscal and monetary policy is not an easy task.