Stagflation refers to the economic situation where there are high levels of inflation, low economic growth, and high unemployment. The word stagflation has essentially been derived by merging the words “stagnated” and “inflation”; thus, it can be thought of as a stagnated economy with high levels of inflation.
The term stagnated economy refers to an economy that sees little or no growth in its GDP. High levels of unemployment are triggered by the inflation prevalent in the economy. These economic factors keep aggravating each other, thereby worsening the economic situation of the economy.
Usually, in the scenario of stagflation, it is possible that any fiscal stimulus or monetary policy implemented to make the economic situation better could rather worsen the situation.
Stagflation is a much more severe case of an economy with inflated prices. Under stagflation, prices are at an unmanageable level as well as the economic growth is not contributing in any way to reduce the inflation rates.
As people lose jobs due to a sinking economy, they also face the pressure of rising prices. This means that the amount of money held by them is constantly losing its value due to inflation. Therefore, people are not able to consume goods due to the lack of jobs and recession. In addition, they are also unable to utilise the money effectively in their hands as its value is gradually falling.
Normally, in a low growth situation, the central bank can provide stimulus to the economy by decreasing interest rates and encouraging public spending. However, under stagflation, policies may not give the expected results.
The concept of stagflation came to light after the 1970s. It was believed that stagflation was not an achievable scenario as the increase in prices were thought to be a by-product of economic growth. Under the concept of the Phillips curve, an increase in unemployment is offset by a decrease in inflation. Thus, both move in opposite direction to balance out each other. Therefore, inflation in the economy was thought to be a normal sign.
This theory did not hold during the great depression, when both unemployment and inflation rose simultaneously. Any policy implemented to counteract inflation would result in even higher unemployment and any policy aimed at curbing unemployment led to an increase in inflation.
The recession of 1973-1975 was termed as stagflation and that is when the term got recognition. There were high rates of unemployment during this time and inflation rates tripled across the economies. There were no visible adjustments in either inflation or unemployment.
There are several factors at play that led to the stagflation of 1970s.
One of the major factors at play was the OPEC oil embargo decision. OPEC decided to not supply oil to the US after the then President Richard Nixon decided to remove the US off the gold standard.
This meant that countries could not redeem US dollars in their foreign exchange reserves for gold. With this decision the US moved out of the Bretton Woods Agreement.
Before the OPEC oil embargo, Richard Nixon announced a certain set of policies in hopes of tackling inflation. However, they ended up leading the US towards stagflation. The policies implemented by Nixon led to a shock in the economy. This was followed by the OPEC oil embargo which triggered the stagflation.
Past experiences have pointed towards the possibility of policy intervention worsening the economic scenario under stagflation.
Monetary policy is one of the strongest tools available to a central bank. However, increasing the supply of money can have adverse effects rather than benefits for an economy. This is exactly what was observed in 1970s. The central bank introduced a lot of money into the economy to increase the demand. However, this influx of liquidity led to higher inflation which ultimately led to an increase in unemployment.
It is a known fact that printing of currency and increased money supply lead to inflation. Thus, the impacts of the Fed’s policies in 1970s were effectively the same as the effects of seigniorage or printing of more money.
Thus, the primary method to combat stagflation would be to avoid allowing too much liquidity seeping into the system. The central bank needs to be alert under the scenario of a recession when stagflation can set in if the right policies are not implemented. The most important lesson from the previous examples is that central banks need to pull money out of circulation when they fear a prolonged price rise.
What is Keynesian economics? Keynesian economics is the economic theory that states demand is the driver of economic growth. This economic theory also states that fiscal aid helps recover an economy from a recession. Certain Keynesian economic principles stand in stark contrast to the Classical theory of economics. The theory was given by John Maynard Keynes in the 1930s and published in Keynes’ “General Theory of Employment, Interest and Money” in 1936. The Keynesian theory stated that government spending was an essential factor in increasing demand and maintaining full employment. What are the theories under Keynesian economics? Aggregate demand is affected by a host of factors: Aggregate demand is affected by various factors public and private factors. Monetary and fiscal policy both affect the level of aggregate demand in the economy. Any decision taken by the monetary authority or the government greatly affects the economy’s level of demand. Say’s Law proposes that supply generates its own demand. However, Keynesian economics suggests that demand is the driver of supply and overall growth in the economy. Sticky Wages: According to the theory of sticky wages, employers would prefer laying off workers over decreasing the existing workers’ wages. This happens because even in the absence of labour unions, workers would still resist wages cuts. Even if the employers were to reduce wages, it would lead to economic depression as demand would fall and people would become more cautious about their spending. Keynes advocated that the labour markers do not function independently from the savings market. Therefore, prices and wages respond slowly to changes in supply and demand. Liquidity Trap: Liquidity trap refers to an economic scenario where there is a contraction in the economy despite very low interest rates. This contrasts with the relationship between interest rates and investment given in Classical economics. How is Keynesian economics different from Classical economics? Classical economics states that the economy self-regulates in case of a disequilibrium. Any deviations from the market equilibrium would be adjusted on its own without any government regulation. However, Keynesian economics propagates that government intervention must maintain equilibrium or come out of an economic downturn. Keynesian economics highlights the importance of monetary and fiscal policy, while Classical economics does not mention any government intervention. Another crucial difference is that Classical economics suggests that governments should always incur less debt, while Keynesian economics advises that governments should practice deficit financing during a recession. Classical economics states that government spending can be harmful as it leads to crowding out of the private investment. However, it has been later established that this happens when the economy is not in a recession. Government borrowing competes with private investment leading to higher interest rates. Thus, Keynesian economics is of the view that deficit spending during a recession does not crowd out private investment. What are the policy measures advocated by Keynesian economics? According to Keynes, adopting a countercyclical approach can help economies stabilise. This means that governments must move in a direction opposite to the business cycles. The theory also states that governments should recover from economic downturns in the short run itself, instead of waiting for the economy to recover over time. Keynes wrote the famous line, “In the long run, we are all dead”. The short run knowledge of the economy would be far better than the long run prediction made by any government. Thus, it makes sense for governments to focus on short run policies and maintain short run equilibrium. Keynes’ multiplier effect states that government spending would increase the GDP by a greater amount than the increase in government spending. This multiplier effect established a reason for governments to go for fiscal support when the economy requires it. What have been the criticisms of Keynesian economics? The initial stages of Keynesian economics propagated that monetary policy was ineffective and did not play any role in boosting economic growth. However, the positive effects of monetary policy are well established and have been integrated into the new Keynesian framework. Another criticism is that the advantage of the fiscal benefits to the GDP cannot be measured. Thus, it becomes difficult to fine-tune the fiscal policy to suit the economic scenario better. Also, the Keynesian belief of increased spending leading to economic growth may lead to the government investing in projects with a vested interest. It could also lead to increased corruption in the economy. The theory of rational expectations suggests that people understand that tax cuts are only temporary. Thus, they prefer to save up the income left behind to pay for future increases in taxes. This is the Ricardian Equivalence theory. Thus, fiscal policy may be rendered ineffective due to this. Supply-side economics has also shown contrast to Keynesian beliefs. During the stagflation in the 1970s, the Phillips curve failed, bringing out the importance of supply-side economics.