Meaning of Stagflation
Stagflation is an economic cycle in which there is high rate of inflation and stagnation. Inflation is when prices of commodities are at an increasing state. Stagnation occurs when an economy faces slow economic growth rate (decline in production).
An economy going through stagflation faces high rates of unemployment during .
Simply, stagflation is an economic situation in which prices are rising, there is a lack of job opportunities, and business firms are not performing well. It is a period of slow economic growth or when the economy is shrinking.
The condition of stagflation can be illustrated with the help of the following diagram:
As shown in the diagram, the initial level of output was Y1 with a general price level of Y1. The output or total supply curve shifts from AS1 to AS2. This states that the supply of goods and services in the economy has declined.
The figure also shows that the general price level of goods and services has increased from P1 to P2 even when the level of output has decreased. This is the rare economic condition of stagflation.
Many economists believed that stagflation was not possible. But, the event of Middle East-imposed oil embargo in 1973 gave rise to stagflation. During this time, there was a substantial rise in price of oil and food prices. This subsequently led to inflation. The scarcity of oil and increasing price levels decreased the supply of commodities.
Causes of Stagflation
Economists have identified two major explanations for the occurrence of stagflation. They believe that stagflation occurs as a result of supply side shock, and inappropriate macroeconomic policies.
Supply side shock
Stagflation occurs when productive capacity of an economy reduces due to supply side shock. Supply shock is the unfavorable disturbances in the supply chain due to rise in price of goods.
For instance, increase in prices slows down economic growth by affecting production and producers. When cost of production becomes high, production itself becomes costly and reduces profit levels of the manufacturing firms.
When prices rise, costs of firms also rise (transport of goods become more costly), so aggregate supply declines. This causes higher rates of inflation and lower output levels.
Inappropriate macroeconomic policies
Stagnation and inflation can occur simultaneously because of inappropriate macroeconomic policies.
For instance, the excess of money supply in the market leads to inflation. This happens when the central authority allows more cash in the economy. Similarly, when government imposes excessive regulation over goods and labor markets, it results in stagnation.
Further, efforts of the government to control inflation may result in decreased productivity. This is because producers would be unwilling to produce at lower profit margins.
Thus, when an economy enters stagflation, any effort made to overcome it, can cause further damage to the economy.