Stagflation

What It Means

Inflation and unemployment are two powerful forces that are considered to be important signs of whether or not an economy is healthy. They usually happen separately (with the first accompanying a strong economy and the second a stagnant one), but occasionally they occur at the same time. This unusual situation is called stagflation (a term coined by combining “stagnant” and “inflation”), and it is a difficult economic situation to solve, because the usual methods of fixing one problem tend to make the other one worse.

One of the primary indicators of an economy’s health is the rate of unemployment, meaning the percentage of the adult workforce that cannot find jobs. Low unemployment figures reflect the fact that businesses are doing well and need employees. When the rate of unemployment goes up (that is, more people lose their jobs), it is usually because economic growth is slowing.

Inflation is a persistent increase in the overall level of consumer prices. As this happens, currency (for instance, the dollar in the United States) loses value. Prices usually rise as a result of high consumer demand for goods and services or excess money in circulation. Thus, inflation is typically considered to be a sign of a strong, expanding economy. Most economists view moderate levels of inflation to be normal if people’s income is growing at a similar rate. But when the general level of prices rises too quickly, consumers’ purchasing power will fall severely.

Inflation rates usually decline when unemployment rates rise, and vice versa; it is rare for inflation and unemployment to increase simultaneously. Stagflation occurs when the two trends overlap: when the economy moves from a normal period of growth (with low unemployment rates and rising prices) to a period in which people lose jobs but prices continue to inflate rapidly.

When Did It Begin

Most of U.S. economic history has been marked by inflation and unemployment occurring separately. Up until the 1970s unemployment had always been considered a much more serious problem than inflation. Before then prices had generally been stable because consumer demand for goods and services had never grown quickly enough to bring on severe rates of inflation.

Several economic factors came together in the early 1970s to stagnate economic growth. Inflation had been growing quickly since the 1960s. The U.S. government was spending more than it was taking in, creating large national debts (deficits). The high inflation rate caused an increase in interest rates (interest is the fee that people pay when they borrow money from banks or other financial institutions). This made it more expensive to get loans, and business investments suffered as a result. Finally, and most importantly, the Organization of Petroleum Exporting Countries (OPEC), an international body that controlled more than half of the world’s oil reserves, imposed a dramatic increase in the price of oil. Because petroleum drove so much of the U.S. economy, this price increase had the effect of raising price levels throughout the economy (that is, it worsened inflation).

By the mid-1970s inflation, which in previous decades had never exceeded 5 percent, had grown to 12 percent; meanwhile the unemployment rate had nearly doubled to 9 percent. This was the first time this economic situation had occurred, causing the creation of the term stagflation. It is not certain who coined the word, but it is usually attributed to British politician Iain Macleod (1913–70), who used it in a speech in 1965.

More Detailed Information

When an economy experiences a period of moderate inflation, the usual reaction of businesses is to increase the production of goods and services, because they will then reap the benefits of the higher prices. But if price increases become excessive and result in increased wages for workers, the businesses that employ them react differently: they will produce less and charge higher prices to make up for the higher costs of machinery, natural resources, and wages. Sometimes the government can take steps to curb inflation and unemployment. When even the intervention of government cannot control these two problems, stagflation sets in.

Although unemployment and inflation are often relatively easy to manage, it can be difficult to address both of them at once. For instance, if the government focused on the unemployment problem, it could try to revive the sluggish economy by stimulating the overall level of demand for consumer goods. But increasing demand usually makes prices rise, so this tactic might increase inflation even further. But if the government attempted to slow inflation (which it could do by, for instance, decreasing the lending power of banks, thereby limiting what citizens can spend), unemployment might worsen. The government can only develop policies to solve stagflation when it can identify what is causing it.

When everyone who wishes to work (at the going wage rate for their type of labor) is employed, it is an economic condition known as full employment. Stagflation can be caused by rising inflation occurring before full employment is reached. In this situation, government policy might include providing more vocational training in areas of industry where there is a shortage of skill.

Neoclassical economic theory, which became a favored economic approach in the final decades of the twentieth century, maintains that stagflation is caused partly by the market’s failure to allocate goods and services efficiently. One possible solution, in this view, is to use monetary policy (that is, decrease the money supply) to counter inflationary pressures. This is what the Federal Reserve (the central bank of the United States) did in the 1980s. Some economists believe that another solution is to increase taxes on consumption, which encourages saving over spending.

Recent Trends

The Federal Reserve tackled the problem of inflation by reducing the U.S. money supply from 1979 to 1983. By 1983 inflation was back down to normal rates, but as a side effect of slowing down inflation, the economy had gone into a recession. The U.S. government then attempted to revive the economy. It employed fiscal policy in the form of tax cuts and also used monetary policy (specifically, lowering interest rates) in order to increase the money supply; these two actions, coupled with a sharp decline in oil prices, helped to create an economic recovery. For the next two decades the condition of the U.S. economy was strong in comparison to the double-digit inflation and recession of the 1970s.

In 2006 the price of oil rose to almost $80 a barrel at the same time that the Federal Reserve was increasing interest rates. These developments, which seemed similar to what had happened in the early 1970s, led some economists to believe that global stagflation might return. The U.S. economy, however, was not nearly as dependent on oil as it was in the 1960s and 70s. Thus, stagflation did not come about, and oil prices gradually dropped to below $60 per barrel.