STAGFLATION

Stagflation refers to an economy experiencing rising inflation but falling output and rising
unemployment at the same time.
Until the 1970s, many economists believed that there was a stable and inverse relationship
between inflation and unemployment. They believed that inflation was tolerable because it
meant the economy was growing and unemployment would be at low levels. Their general
belief was that an increase in the demand for goods drives up prices, which in turn
encourages firms to expand and hire additional employees, creating additional demand
throughout the economy.
In the 1970s following the tripling in the price of oil., however, a period of stagflation - or
slow growth along with rapidly rising prices - raised questions about the assumed relationship
between unemployment and inflation. Again, a degree of stagflation occurred in 2008,
following the rise in the price of oil and the start of the global recession.

Because stagflation was long believed to be impossible as the economic theories that
dominated academic and policy circles ruled it out of their models. In particular the economic
theory of the Phillips Curve which stated that inflation and unemployment have an inverse
relationship. The theory claims that with economic growth comes inflation, which in turn
should lead to more jobs and less unemployment.

But the behaviour between inflation and unemployment amid stagnant growth proved this
there is much more to the story.
The term "stagflation" was first used during a time of economic stress in the United Kingdom
by Iain Macleod in 1965. It was later used again to describe the recessionary period during
the 1970s following the oil crisis, when the U.S. underwent a recession that saw five quarters
of negative GDP growth. Inflation doubled in 1973 and hit double digits in 1974;
unemployment hit 9 percent by May 1975.
Stagflation was majorly recognized where many developed economies experienced rapid
inflation and high unemployment as a result of an oil shock in the 1970’s. Since the 1970's,
rising price levels during periods of slow or negative economic growth have become
somewhat of the norm rather than an exceptional situation.

Theory on causes of Stagflation: -

 A theory states that this economic phenomenon is caused when a sudden increase in
the cost of oil reduces an economy's productive capacity. In October 1973,
the Organization of Petroleum Exporting Countries (OPEC) issued an embargo against
Western countries. This caused the global price of oil to rise dramatically, therefore
increasing the costs of goods and contributing to a rise in unemployment. Because
transportation costs rise, producing products and getting them to shelves got more
expensive and prices rose even as people got laid off.

 It was also observed that it was a result of poorly made economic policy. Harsh
regulation of markets, goods and labour in an otherwise inflationary environment are
cited as the possible cause of stagflation. Some point fingers to the policies set in
place by former President Richard Nixon,. Nixon put tariffs on imports and froze
wages and prices for 90 days, in an effort to prevent prices from rising. The sudden
economic shock of oil shortages and rapid acceleration of prices once the controls
where relaxed led to economic chaos, hence stagflation.

Additional reasons for stagflation: -

1. Oil price rise -  Stagflation is often caused by a supply-side shock. For example, rising
commodity prices, such as oil prices, will cause a rise in business costs (transport
more expensive). This leads to a rise in the general prices in the economy, demand for
the product goes down and short-run aggregate supply will shift to the left. First
instances of stagflation were observed because of tripling of the oil prices.

2. Falling productivity - If an economy experiences falling productivity – workers

becoming more inefficient; cost rises and output fall. This leads to low production
resulting in higher prices and high inflation. Lower profits drive the firms to let go off
their workers in order to cut costs and this vicious cycle continues.

3. Rise in structural unemployment - If there is a decline in traditional industries, we

may get more structural unemployment and lower output. Thus, we can get higher
unemployment – even if inflation is also increasing.
Stagflation led to the emergence of the MISERY INDEX
This index equals the sum of the inflation rate and the unemployment rate, the original misery
index was popularized in the 1970s as a measure of America’s economic health

 The first misery index was created by Arthur Okun and was equal to the sum of
inflation and unemployment rate figures to provide a snapshot of the US economy.
 The higher the index, the more is the misery felt by average citizens.

CASE EXAMPLE OF THE UK ECONOMY (1970s)

The above graph shows the situation of stagflation in the UK economy in the 1970s
especially in 1973 and 1979. Key observations from the graph can be summarised as
follow: -

1. The 1970 pre economy was showing conventional signs as when GDP showed
growth there was a simultaneous increase in the inflation i.e. conventional wisdom
from economic policies stood its ground.
2. There was a positive relationship between GDP growth and inflation as described
by the Philips curve. More growth meant more demand for goods, more creation
of jobs hence rise in the general price level.
3. From 1970-73, the economy of UK boomed by almost 5% and pushed the
inflation in the same direction as inflation rose by the same 5%.
4. But the post 1973 economic behaviour shocked the policy makers and the concept
of stagflation emerged as negative relation between GDP growth and inflation
emerged for the first time.
 5. In 1973 and 1979 especially, GDP showed negative growth and inflation was
growing at a positive rate.
6. In 1973- GDP declined by -6% and inflation soared ~18%.
7. The main reason behind this was the oil price boom and rising wages (powerful
trade unions) which made goods extremely expensive to produce leading to a
negative consumer sentiment as people resorted to buying less, demand went
down even though inflation reached an all-time high.

U.S.A.: CHANGE IN PHILIPS CURVE

During the 1970s especially from 1970 to 1979, the U.S. economy showed signs of
stagflation which was captured by the rightward movement in the Philips curve. Following
observations can be made by interpreting the above graph: -

1. Due to the rise in oil prices, inflation shot up and it was high by U.S. historical
standards: core consumer price index (CPI) inflation—that is, excluding food and fuel—
reached an annual average of 13.5% in 1980.
2. Unemployment was also high with uneven growth; the economy was in recession
from December 1969 to November 1970, and again from November 1973 to March
1975.
3. The US economy faced a worse trade off- there was higher inflation and higher
unemployment and as a result, Phillips curve shifted to the right.
Solutions to Stagflation: -

1. Deflationary policies - The primary macroeconomic objective should be to reduce

inflation. Reducing inflation may cause higher unemployment and lower economic
growth in the short-term. But this unemployment is a ‘price worth paying’ for higher
inflation. Decrease in price levels will induce the consumers to buy more creating
high demand and high employment in the long run.

2. Supply-side solutions - One solution to stagflation is to increase aggregate supply

(AS) through supply-side policies, for example, privatisation and deregulation to
increase efficiency and reduce costs of production. This is a long-term solution which
is needed to be implemented with great due diligence.

3. Wage control - In the 1970s, part of the stagflation was caused by rising wages
(powerful trade unions). In order to curb that wage control policy can be introduced –
government intervention to limit wage rises. Limiting wage increases can break the
cycle of wage inflation and help to improve the economic situation.

SOURCES: -

1. https://en.wikipedia.org/wiki/Stagflation
2. https://www.investopedia.com/articles/economics/08/1970-stagflation.asp
3. https://www.bls.gov/
4. https://www.ons.gov.uk/economy/economicoutputandproductivity/output/articles/cha
ngesintheeconomysincethe1970s/2019-09-02