The 3 Major Economic Components Necessary for Stagflation to Occur

Stagflation is most commonly referred to as the simultaneous experience of three separate negative economic phenomena: rising inflation, rising unemployment, and the declining demand for goods and services.

Despite several examples of Western economies during the 19th and 20th centuries experiencing stagflation, many economists did not believe that stagflation could exist because of the Phillips curve, which viewed inflation and recession as diametrically opposite forces.

The term “stagflation” was made popular in 1965 by a member of the British Parliament, Iain Macleod, who told the House of Commons that the U.K. economy “had not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of “stagflation”.

However, stagflation wouldn’t gain worldwide renown until the mid to late 1970s, when more than a dozen economies, including the U.S., went through a period of rising prices and unemployment.

Inflation, Unemployment, and Recession

Inflation

Inflation refers to an increase in the supply of money (money stock) that causes the general level of prices in the economy to go up. When more units of money are available to chase the same number of goods, the law of supply and demand dictates that each individual money unit becomes less valuable.

Not every rise in prices is considered inflation, however. Prices can rise because consumers demand more goods or because resources become scarcer. Indeed, prices frequently rise and fall for individual commodities. When prices rise as a result of an over-abundance of money stock, it is called inflation.

Unemployment

Unemployment refers to the percentage of the workforce that would like to find a job but is unable to. Economists often differentiate between seasonal or frictional unemployment, which occurs as a natural part of market processes, and structural unemployment (sometimes called institutional unemployment).

Structural unemployment is more controversial; some believe that governments must intervene to solve structural unemployment while others believe that government intervention is its root cause.

Recession

Recession is commonly defined as two consecutive quarters of negative economic growth as measured by gross domestic product (GDP). It is also known as economic contraction.

The National Bureau of Economic Research (NBER) states that recession is “a period of diminishing activity rather than diminished activity.” Typically, recessions are characterized by falling demand for existing goods and services, declining real wages, temporary increases in unemployment, and an increase in savings.

Battling Stagflation

Though rare, stagflation is a possible scenario in an economy. The last time it occurred in the U.S. was in the 1970s. Contemporary monetary or fiscal policy is ill-equipped to handle a period of stagflation.

The policy tools prescribed by macroeconomics to combat rising inflation include reduced government spending, increased taxes, rising interest rates, and the raising of bank reserve requirements. The remedy for rising unemployment is exactly the opposite: more spending, fewer taxes, lower interest rates, and encouraging banks to lend.

To battle stagflation appropriately when it occurs, economists must understand what the driving factors are. Keynesian economics suggests that shocks to the economy, such as an increase in energy or food inventory cause stagnation. Milton Friedman and his school of thought believe it is a result of accelerated expansion of the money supply.

One solution to battle stagflation has been proposed by the economist, Robert A. Mundell. He believes the goal is to increase production in the economy while simultaneously restricting the money supply. This can be achieved in a variety of ways, such as by cutting tax rates for companies and individuals, which will increase their purchasing power.

Monetary restraint can be achieved by increasing bank reserves and rates on borrowing, which limit the ability to borrow. These two scenarios would create a high demand for money and allow for expansion at higher rates, which results in noninflationary growth.

The Bottom Line

Stagflation is a unique economic condition, a negative one at that, that requires rising inflation, rising unemployment, and declining output all to occur at the same time. There are different theories on how to cure stagflation; however, since it has not happened often, many of these theories are untested.

Current monetary policy has generally worked well in handling times of recession and inflation, though is not necessarily equipped to handle the complexities of stagflation.