What is Stagflation?

Economics is the study of commercial activity in an area specifically a country and how the money flows in a country or the value of goods and services produced, distributed and consumed, inflation, cost, industry, demand & supply, per capita income, national income, stages of development in a country and trust me, a lottttttt more! 🤯🤯🤯 

It's not wrong to say that economics at its very core is the study of people. Where you can find out what macro and micro factors affect the dynamics of a country. 

To understand finance it is important to understand Economics along with it. And today we bring to you one such economic concept and that is Stagflation. 

So let's get started.

Understanding Stagflation

Imagine, the economy is growing, the rate of unemployment is going down, inflation is under control, almost every industry is flourishing, and everyone is happy. So good! But don't forget it's only imagination and in reality, this rarely happens.

In reality, if there is growth it will be followed by high inflation, if there is more demand it can be followed by less supply and vice versa. And in one of the worst-case scenarios, there is slow economic growth followed by higher inflation & unemployment. This worst-case scenario my friend is called Stagflation. 

As it is depicted in the image below:

Thus, Stagflation can be defined as a period of increased inflation combined with stagnant economic growth and unemployment.

This term was initially coined by Lian Macleod in the early ’60s when the UK was under great economic stress. You see, he was talking about “inflation” on one side and “stagnant” growth on the other side. That's how the term Stagflation is a combination of stagnant & inflation. 

In the ’70s the concept was again used in the US when the country underwent a recession followed by rising oil prices that saw five quarters of negative GDP growth.

Stagflation was experienced by many countries globally in the 1970s due to rising oil prices and this led to the birth of the Misery Index.

By the way, there is always confusion that Stagflation & Inflation is closely related. They are related but with differences which we are about to discuss.    

Stagflation vs Inflation

We are talking non-stop about inflation & stagflation. Where stagflation is a situation of High unemployment & inflation followed by no growth. Now, what is inflation then? 

Inflation is a term in economics used to describe excessive price increases. It is the rate at which the prices of goods and services in the economy increase or the rate at which the purchasing power declines. 

For eg. If inflation is at 5% and you spend ₹100 on groceries in a month that following year you need to spend ₹105 to purchase the same number of items. But if you stick to your usual budget of ₹100 then you won't be able to buy the same number of items. 

Now the next question must be, How is stagflation different from inflation. Well, there are various points of difference between the two as the rate at which the price of goods and services in the economy increases is inflation whereas, in a situation of stagflation, it consists of unemployment and low growth followed by inflation. 

Inflation is natural & expected and can be managed while stagflation could be hard to manage. Inflation is caused by multiple factors such as demand-pull, cost-push or inbuilt factors in the economy.

Stagflation is caused mainly due to harsh economic policies followed by an increase in the money supply. Such as if the government prints currency this results in an increase in money supply in the market which causes inflation but at the same time if the government will increase the tax rate it will slow economic growth causing stagflation. 

That was all about inflation & stagflation. Also, there are various theories about stagflation as discussed below. 

Stagflation Theories

Well, the human mind has come up with various theories as to why stagflation takes place in the economy. Listed below are several arguments by economists as to why stagflation takes place.

A rise in Oil Prices

This theory depicts that stagflation occurs due to the rise in Oil Prices. As oil is used to manufacture a number of products in a country. A rise in its price will cause stagnation in the production capacity in the country and also this will give rise to the cost of goods and services. This happened in the early ’70s when the oil embargo crisis took place. It was a dispute between OPEC & Western countries.

Which gave rise to global oil prices that gave rise to the cost of production and transportation cost. Thus, production & distribution became expensive. When things became expensive it gave rise to inflation followed by unemployment. And this caused growth to become stagnant.

Thus, a rise in oil prices can impact an economy in adverse ways.

Mismanaged Economic Policies

Poorly managed economic policies also cause Stagflation. 

It is depicted that the policies formed by former US president Richard Nixon may have triggered the recession of the 1970s where he put tariffs on imports and froze wages and prices for 90 days in order to prevent prices to rise. This caused a sudden decrease in the supply of goods, oil shortage and a rise in price at an accelerated rate which led to economic chaos.

Supply shock theory

According to this theory, Stagflation occurs when an economy faces a sudden increase or decrease in the supply of goods and services. Just like what happened in the example above when imports were restricted all of a sudden causing the oil prices to rise. 

This kind of volatility in prices makes production costlier and less profitable which slows down the economic growth. 

Uncertain Situation

Well, this is not an economic theory for stagflation but an opinion. An uncertain situation such as the outbreak of the war between two countries or a pandemic-like situation can also give rise to stagflation. 

As the Covid19 pandemic took place it gave rise to unemployment all around the world and the growth was obviously hampered. And to date, inflation is on a rise. 

Whereas a war-like situation going on between Russia & Ukraine has plunged the value of the rouble (Russian currency) against the Dollar by more than 60%. Also, the disruption in supply has resulted in rising in prices of several key commodities such as crude oil and gas.

This may adversely impact the rate of unemployment, inflation and growth.

So, these are some of the reasons why stagflation can take place. The most remarkable situation arose in the 1970s. Take a look at what happened. 👇

Stagflation in 1970

There are only a few examples in the history of Stagflation. One of the most notable ones happened in the 1970s in the US. Let us understand it now. 

In the 1970s monetary policy was too loose. The money supply was growing faster than the economy which led to inflation. People started to expect inflation and economic decisions were made keeping inflation in mind led to even more inflation. High inflation followed by high oil prices led to recession and unemployment. These were all ingredients of stagflation. 

In 1979 Paul A. Walker became the chairman of federal reserves. Under his leadership, federal reserves raised the federal funds rate (The rate at which banks lend to each other) which brought inflation down and eased the stagflation situation. 

The Bottom Line

It has become a topic of debate that the Indian economy is moving towards stagflation. Slow growth is expected to happen because there are both supply-side & demand-side issues since there are a lot of companies that want to produce but can not due to supply issues of items such as semiconductor chips, oil etc to make their finished products this is creating supply-side issues whereas companies like Asian paints & HUL have increased the prices of products by 15-20% and consumers are reluctant to buy these products now which is creating demand-side issues. 

Both these factors combined are expected to create slow growth & high inflation which might lead to a stagflation problem.

What do you think about it? Tell us in the comment section.

Isn't it great that you learned about stagflation beforehand right? I know learning is great! 

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That was all for today. Until next time, Happy learning! :)