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Stagflation
Sunday, 19 June 2011 15:35
Stagflation is unique situation where there is high inflation coupled with stagnant economy with
low income and employment rates. Inflation is a result of high growth which increases the
income and correspondingly increases the demand, thereby leading to hiking of prices.
Stagnation on the other hand results from low demand, leading low output resulting into
collapse. Stagflation is contraction of stagnant and inflation. Inflation or stagnant economy in
itself is a difficult situation for any country. This is why stagflation is so dangerous. Imagine a
scenario in which you have both a sinking economy and runaway inflation. With high
unemployment, consumers have less money to spend. Add inflation, and the money they do
have is worth less and less every day.
What are the causes of stagflation?
Stagflation can be result of supply side shock. Imagine a situation where a country is already
suffering from stagnation and high unemployment. This country is also very big importer of oil.
Suddenly there is rise in the oil prices. Increase in oil prices govern corresponding rise in the
other commodity prices. Oil being the major commodity in most of the production activities, any
price rise in the oil increase the overall production cost. In order to cover for the rise in the
production cost, the manufacturing units need to increase the price of the commodities. Thus
the combined effect of stagnant economy and increase in the price of essential commodity lead
to stagflation.
Stagflation can also be caused by mismanaged macroeconomic policies. Central banks can
increase money supply in order to increase the money supply and provide spurt to the
economy. These actions are bound to increase the prices of commodities. These policies need
to be complemented by appropriate labor and goods policies. If there is mismatch between
monetary policies and labor & good policies, it may lead to decrease in production. If such a
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Stagflation
Sunday, 19 June 2011 15:35
situation continues for long time, then it may lead to stagflation.
During the recession countries suffers from reduced output in terms of GDP and increase in
unemployment. The threat of stagflation is greatly increases during recession. According to
standard monetary policy, the central bank across the world lowers interest rates during a
recession to encourage borrowing and spending. The key to preventing stagflation is to avoid
allowing too much money to enter the economy too quickly.
We just saw above terms inflation and stagflation. There are two other key terms, deflation and
hyperinflation. Deflation is decline in general price level caused by reduction in supply of money
or credit. It is often caused by contractions in spending either in the form of reduction in
government spending, personal spending or investment spending. Deflation has side effect of
increasing unemployment in the economy, since it leads to lower level of demand in the
economy.
Hyperinflation is a condition in which prices rises very rapidly and currency loses value.
Hyperinflation is mainly caused by an extremely rapid growth in the supply of paper money. It
occurs generally when government recklessly prints currency to fund its expenditures. The
growth in the output of goods and services is exceedingly inferior to the money printed out. The
rate at which the government is printing the money is lesser than the rate at which it is getting
devalued; hence the value of currency keeps on going in the downward direction.
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