What is stagflation?

The word ‘stagflation’ might conjure images of a blow-up deer, but the phrase actually describes a set of economic conditions that are far from comical. So what exactly is stagflation, what are its causes and what can it mean for the economy?

What is stagflation in an economy?

Stagflation is a combination of the words ‘stagnation’ and ‘inflation’. It refers to an economic condition where three factors are present – slow economic growth, high unemployment and rising goods prices. The first two of these are signs of economic stagnation, while the third is a sign of inflation. When all three occur at once, the economy is said to be in a period of stagflation.

The term is believed to have originated in the UK in 1965, when MP Iain Macleod used it in a speech to parliament. Addressing the state of the UK economy at the time, he said: “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.”

What causes stagflation in an economy?

Economists have pointed to two main causes of stagflation, these being supply shock and poor economic policy.

Supply shock

A supply shock is an event that suddenly causes the supply of a particular commodity or service to increase or decrease. If supplies of a particular commodity or service run suddenly and unexpectedly short, prices might be expected to increase as a result. If, for example, supply of a commodity like oil suddenly ran short because of a trade embargo or some other factor, this could affect the production and transportation of goods, in turn slowing economic growth and leading to a situation of stagflation.

Poor economic policy

It may also be the case that poor economic policy can lead to stagflation in an economy. Say, for example, a government makes a policy that increases money supply while simultaneously making policies that slow growth. This could occur if a hypothetical government decided to print a large amount of currency rapidly, while also increasing taxes or raising official interest rates. This could have the cumulative effect of raising inflation while hampering industry, thereby slowing economic growth and raising unemployment. This would also be a situation of stagflation.

What are the effects of stagflation?

The effects of stagflation can be seen in the example of the US economy in the 1970s. In 1978-79, the price of oil skyrocketed, in part influenced by booming global demand and a decrease in oil production in Iran following the revolution there. This so-called ‘oil shock’ came at the end of a decade of rising inflation and unemployment in the US, and rising fuel prices drove the price of goods even higher.

Prevailing economic theories at the time held that there was an inverse relationship between inflation and employment – in short, that inflation was a sign of a growing economy, and that demand for goods and services would cause companies to expand, thereby driving down unemployment. The effects of the ‘oil shock’ on the US economy showed that this was not always the case.

Stagflation can have a negative impact on both the financial health of an economy, and the emotional wellbeing of people within it. In fact, the combined effects of stagflation on everyday people in a society can be estimated on a scale known as the misery index.

The misery index is calculated by adding the unemployment rate to the inflation rate. High inflation means lower buying power for the average person, while high unemployment means more people out of work, and therefore not earning wages to support themselves and their families. High levels of both are therefore said to lead to misery for the average person, and this is the ultimate effect of stagflation. That said, some critics have described the misery index as a fairly imprecise and simplistic metric, so it’s important to note it shouldn’t be seen as a foolproof way of working out the effects of stagflation.

How do you fix stagflation?

There is no easy or definitive way to ‘fix’ stagflation. One problem with trying to remedy the situation is that the traditional approaches to fixing the key problems of high inflation and high unemployment tend to be opposed to each other. When responding to high inflation, a government might cut spending in order to restrict money supply and slow down the economy, thus hopefully reducing consumer spending.

Conversely, when responding to high unemployment, a government might pump money into the economy to encourage businesses to grow and hire more people. In a situation of stagflation, when there is both high unemployment and high inflation, it is not practical for a government to do both.

In the early 1970s, economist Robert Mundell proposed that a mix of monetary policies is a way to counter stagflation. He wrote: “The correct policy mix is based on fiscal ease to get more production out of the economy, in combination with monetary restraint to stop inflation. The increased momentum provided by the tax cut will cause sufficient demand for [money] to permit real monetary expansion at higher rates.”

More recently, Australian economist Saul Eslake told the ABC that the best way for governments to ultimately break free of stagflation historically has been to focus on policies that would expand the potential growth rate of the economy.

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