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Stagflation

Stagflation

EXPLANATIONS FOR STAGFLATION

POLICY RESPONSES

BIBLIOGRAPHY

Two main yardsticks of a modern economys performance are the rate of growth in the production of goods and services and the inflation rate. When the production of goods and services is growing slowly or is falling (generally accompanied by a rising unemployment rate), stagnation occurs. When the prices of goods and services are rising, inflation occurs. Stagflation, a term attributed to the British politician Iain Macleod, refers to a situation in which an economy experiences stagnation and inflation simultaneously.

As recently as the 1960s, the conventional wisdom in macroeconomics was that inflation and stagnation could not appear at the same time. Economists generally believed that there was a stable, inverse relationship between the rate of inflation (the percentage change in the average level of prices) and the unemployment rate (the percentage of the labor force that is unemployed) as illustrated by the Phillips curve, made famous by the New Zealand economist A. W. H. Phillips (19141975). The Phillips curve presented policymakers with a trade-off: They could lower unemployment by stimulating demand but at the cost of higher inflation; or they could lower inflation but at the cost of higher unemployment. Policy discussions in the 1960s centered on which point on the Phillips curve was most desirable.

Consistent with the Phillips curve trade-off, the 1960s saw inflation in the United States increase and unemployment decline, with the unemployment rate falling to 3.5 percent by 1969 while inflation rose to 6.2 percent. In 1970, however, the unemployment rate increased substantially to 4.9 percent with little decrease in inflation. This was the start of a dismal decade for the large industrialized economies. As a whole, the Group of Seven (the seven largest capitalist economies) saw inflation double and real growth halve compared to the 1960s. This experience of relatively high inflation, slow growth, and high unemployment kindled interest in the causes of stagflation.

EXPLANATIONS FOR STAGFLATION

Economists developed two explanations for stagflation in industrialized economies. The first sees stagflation as a phase in an economic cycle that begins with excessive growth in spending, typically fueled by higher-than-normal growth in the money supply. Initially the growth in spending causes prices to rise and, in response, firms to expand production and employment so that the economy experiences higher inflation and lower unemployment. As argued by the American economists Milton Friedman (19122006) and Edmund S. Phelps (b. 1933), the decline in unemployment results from the higher inflation being unexpected so that real wages (i.e., wages adjusted for inflation) fall. Lower real wages lead workers to demand higher real wages, commensurate with higher expected inflation, in the second phase of the economic cycle, causing the unemployment rate to rise back toward what Friedman called the natural rate of unemployment, the level of unemployment that occurs when actual and expected inflation are equal.

The first explanation fits the U.S. stagflation of 1970. According to this view, the rising inflation of the 1960s caused expected inflation to increase, shifting the Phillips curve up in 1970, with the result that inflation remained high while the unemployment rate rose. The U.S. wageprice controls of the early 1970s were an attempt to lower expected inflation and shift the Phillips curve downward, in the hope of reducing inflation without having to increase unemployment.

The second explanation for stagflation focuses on autonomous events that make production more expensive and cause firms to raise their prices. This view is more relevant to the general stagflation of the later 1970s, the source of which is thought to have been the large increases in oil prices in 1973 and 1979. Given that energy is an important component of most goods, a large increase in energy prices increases the costs of production for most firms. Firms are willing to supply the same level of output only if their prices rise. The oil price increase is referred to as an aggregate supply shock. It triggers firms to raise prices and lower output. An adverse supply shock such as a large increase in energy prices shifts the Phillips curve upward and again results in both inflation and rising unemployment.

Not all economists believe that the stagflation of the later 1970s can be blamed on oil prices. Robert B. Barsky and Lutz Kilian (2002), for example, believe the first explanation holds for this episode too. They argue that the stagflation occurred largely because policymakers believed the natural rate of unemployment was lower than it actually was, leading them to overstimulate spending in a misguided attempt to push down the unemployment rate. The explanations are not mutually exclusive so that both may have contributed to the stagflation of the 1970s. An adverse supply shock should not cause sustained higher inflation unless accompanied by higher rates of growth in the money supply.

Developing countries, particularly in Latin America, have often suffered bouts of stagflation. An alternative explanation for stagflation in such economies focuses on the macroeconomic effects of exchange rate devaluations, as analyzed for example by Paul Krugman and Lance Taylor (1978). Most developing economies have fixed nominal exchange rates. If there is a balance of payments deficit, international agencies often prescribe a devaluation of the currency in order to reduce trade deficits. Such devaluations, however, may lead to short-run decreases in output along with higher inflation. Given rigidity in nominal wage rates and prices marked up from costs, the devaluation can result in reduced domestic aggregate demand because of the redistribution of income away from labor, which is assumed to have a higher marginal propensity to spend. Domestic demand can also fall from the decline in real money holdings as prices rise in response to higher import costs and from the increase in ad valorem taxes on imports. Thus devaluations can lead to periods of stagflation.

POLICY RESPONSES

The appropriate policy response to stagflation depends on its cause. If the stagflation is the result of policy-initiated excessive stimulation of spending so that the unemployment rate falls below the natural rate initially and then rises along with inflationary expectations, policymakers need to admit their error and to convince people that they should not build higher inflation rates into contracts. The problem, of course, is that people will be skeptical, so that the policymakers will need to establish credibility that they are truly adverse to inflation.

The suitable response to stagflation caused by aggregate supply shocks is less clear. One response is to do nothing and let the economy adjust as best it can to the shock. If energy prices will be permanently higher, the economy needs to make the changes to the new environment. The likely outcome is a short burst of inflation and a rise in unemployment followed by a gradual return to lower unemployment and stable prices. If energy price increases are temporary, policymakers may choose either to reduce the unemployment effects (by stimulating spending and increasing inflation) or to reduce the inflation effects (by restricting spending and increasing unemployment). The latter choice was the one taken by the administration of Gerald R. Ford after the 1973 oil price shock when it tightened monetary and fiscal policy in 1974 and exhorted households to cut spending as part of President Fords famous Whip Inflation Now (WIN) campaign. The result was a large increase in unemployment with a peak unemployment rate of 8.5 percent in 1975.

Beginning in the early 1990s, inflation targeting by central banks has been advocated as a solution to the first cause of stagflation. If adopted, however, this policy will make the unemployment effects of supply shocks more severe because the response of policymakers will be to reduce spending growth in order to slow the inflation rate. A flexible inflation target that allows for short-run bursts of inflation from supply shocks is one possible remedy.

SEE ALSO Inflation; Phillips Curve; Recession; Unemployment

BIBLIOGRAPHY

Barsky, Robert B., and Lutz Kilian. 2002. Do We Really Know That Oil Caused the Great Stagflation? A Monetary Alternative. In NBER Macroeconomics Annual 2001, eds. Ben S. Bernanke and Kenneth Rogoff, 137182. Cambridge, MA: MIT Press.

Blinder, Alan S. 1979. Economic Policy and the Great Stagflation. New York: Academic Press.

Bruno, Michael, and Jeffrey D. Sachs. 1985. Economics of Worldwide Stagflation. Cambridge, MA: Harvard University Press.

Krugman, Paul, and Lance Taylor. 1978. Contractionary Effects of Devaluation. Journal of International Economics 8 (3): 445456.

Douglas K. Pearce

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Stagflation

STAGFLATION

STAGFLATION is a term referring to transitional periods when the economy is simultaneously experiencing the twin evils of inflation and high unemployment, a condition many economists as late as the 1950s considered a typical of the U.S. economy. Stagflation occurs when the economy is moving from an inflationary period (increasing prices, but low unemployment) to a recessionary one (decreasing or stagnant prices and increasing unemployment). It is caused by an overheated economy. In periods of moderate inflation, the usual reaction of business is to increase production to capture the benefits of the higher prices. But if the economy becomes overheated so that price increases are unusually large and are the result of increases in wages and/or the costs of machinery, credit, or natural resources, the reaction of business firms is to produce less and charge higher prices.

The term first came into use in the mid-1970s, when inflation soared to 12 percent and the unemployment rate nearly doubled to 9 percent. This inflation was the result of the quadrupling of oil prices by the Organization of Petroleum Exporting Countries (OPEC), increases in the price of raw materials, and the lifting of Vietnam-era government-imposed price and wage controls. At the same time, the economy went into recession. In 1979 the high inflation rate was sent spiraling upward when OPEC doubled petroleum prices after the Iranian revolution. President Jimmy Carter established the Council on Wage and Price Stability, which sought voluntary cooperation from workers and manufacturers to hold down wage and price increases. The council could not control OPEC, however, and repeated oil-price hikes thwarted the council's efforts. Years of continued inflation and high unemployment was one of the factors that undermined the Carter presidency and Democratic Party proposals for welfare reform, national health insurance, and reform of labor law.

In 1980, after years of double-digit inflation the Federal Reserve Board (Fed), under Paul Volcker, prodded banks to raise interest rates to record levels of more than 20 percent to induce a recession and break the inflation cycle. Subsequently the Fed pursued a monetary policy designed to head off significant increases in inflation, but in 1994–1995, seven Fed increases in short-term interest rates failed to moderate economic growth. This led to speculation that in a global economy, domestic monetary policy may not be as effective in controlling stagflation as previously thought.

BIBLIOGRAPHY

Ferguson, Thomas, and Joel Rogers, eds. The Hidden Election: Politics and Economics in the 1980 Presidential Campaign. New York: Pantheon Books, 1981.

Greider, William. Secrets of the Temple: How the Federal Reserve Runs the Country. New York: Simon and Schuster, 1987.

Lal, Deepak, and Martin Wolf, eds. Stagflation, Savings, and the State: Perspectives on the Global Economy. New York: Oxford University Press, 1986.

Weintraub, Sidney, and Marwin Goodstein, eds. Reaganomics in the Stagflation Economy. Philadelphia: University of Pennsylvania Press, 1983.

ErikBruun/c. p.

See alsoBanking: Overview ; Federal Reserve System ; Oil Crises .

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Stagflation

STAGFLATION


"Stagflation" is a combination term, bringing together two words, "stagnation" and "inflation." In economic terms, stagflation exists when there is slow or no growth in the real (inflation-adjusted) economy, accompanied by economic inflation (rising prices). A period of stagflation exists, for instance, when unemployment rates are high and the rates of inflation of products are also high. In 1982 the Council of Economic Advisers reported that there was no known reason to expect any regular or systematic association between the unemployment rate and the average rate of price-level change (inflation). The term came into existence during the 1970s, when the effort to reduce high inflation by trading inflation for increased employment actually resulted in both more inflation and rising unemployment: stagflation. Some economists argued that a permanent reduction in inflation brings about a permanent rise in the rate of unemployment, a famous economic tradeoff implied by the 'Phillips Curve,' developed by English economist A.W. Phillips. Phillips' theory was based on his study of English unemployment between 1862 and 1957, where it appeared that any economy would need to accept some growing rate of reasonable inflation in order to lower unemployment. The Phillips Curve data has never been proven to be accurate, according to data gathered in the United States, and the rare and episodic economic conditions of stagflation are still not clearly understood, except that the effort to reduce inflation by artificially increasing employment is by no means reliable, and may result in the paradoxical situation of stagflation, where prices on consumer items increase, but consumers are unable to afford the higher prices.

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stagflation

stagflation, in economics, a word coined in the 1970s to describe a combination of a stagnant economy and severe inflation. Previously, these two conditions had not existed at the same time because lowered demand, brought about by a recession (see depression), usually produced lower, or at least stable, prices. Large U.S. government deficits and sharp rises in the costs of energy have been cited as the chief causes of stagflation in the 1970s.

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stagflation

stagflation A combination of inflation and stagnation in the economy. A situation that arose in Britain and other economies since the late 1960s, as accelerating inflation fed through into price expectations and wage demands.

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stagflation

stag·fla·tion / ˌstagˈflāshən/ • n. Econ. persistent high inflation combined with high unemployment and stagnant demand in a country's economy.

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"stagflation." The Oxford Pocket Dictionary of Current English. . Encyclopedia.com. 26 May. 2017 <http://www.encyclopedia.com>.

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