Two main yardsticks of a modern economy’s 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 (1914–1975). 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.
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 (1912–2006) 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.
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 Ford’s 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
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, 137–182. 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): 445–456.
Douglas K. Pearce
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.
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.
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.
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.
"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.