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Stagflation Definition
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In economics, stagflation, a portmanteau of stagnation and inflation, is a
situation where the inflation rate is high, the economic growth rate slows down,
and unemployment remains steadily high. It raises a dilemma for economic
policy since actions designed to lower inflation may exacerbate unemployment,
and vice versa.
The term is generally attributed to a British Conservative Party politician who
became chancellor of the exchequer in 1970, Iain Macleod, who coined the
phrase in his speech to Parliament in 1965.
Keynes didn't use the term, but some of his work refers to the conditions most
would recognise as stagflation. In the version of Keynesian macroeconomic
theory which was dominant between the end of WWII and the late-1970s,
inflation and recession were regarded as mutually exclusive, the relationship
between the two being described by the Phillips curve. Stagflation is very costly
and difficult to eradicate once it starts, in human terms as well as in budget
deficits.
One economic indicator, the misery index, is derived by the simple addition of
the inflation rate to the unemployment rate.
The Great Inflation
The term stagflation was first coined during a period of inflation and
unemployment in the United Kingdom. The United Kingdom experienced an
outbreak of inflation in the 1960s and 1970s. As early as 17 November 1965,
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Iain Macleod, the spokesman on economic issues for the United Kingdom’s
Conservative Party, warned of the gravity of the UK economic situation in the
House of Commons: "We now have the worst of both worlds—not just inflation
on the one side or stagnation on the other, but both of them together. We have a
sort of “stagflation” situation. And history, in modern terms, is indeed being
made."
With these words, Macleod coined the term ‘stagflation’. In a Bank of England
working papers series article authors, Edward Nelson and Kalin Nikolov, (2002)
examined causes and policy errors related to the Great Inflation in the United
Kingdom in the 1970s, arguing that as inflation rose in the 1960s and 1970s,
UK policy makers failed to recognize the primary role of monetary policy in
controlling inflation. Instead, they attempted to use non-monetary policies and
devices to respond to the economic crisis. Policy makers also made "inaccurate
estimates of the degree of excess demand in the economy, contributed
significantly to the outbreak of inflation in the United Kingdom in the 1960s
and 1970s.
Stagflation was not limited to the UK, however. Economists have shown that
stagflation was prevalent among seven major economies from 1973 to 1982.
[notes 3] After inflation rates began to fall in 1982, economists' focus shifted
from the causes of stagflation to the "determinants of productivity growth and
the effects of real wages on the demand for labor".
Causes
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Economists offer two principal explanations for why stagflation occurs. First,
stagflation can result when the productive capacity of an economy is reduced by
an unfavorable supply shock that causes an increase in the price of oil for an oil
importing country. Such an unfavorable supply shock tends to raise prices at the
same time that it slows the economy by making production more costly and less
profitable. Milton Friedman famously described this situation as "too much
money chasing too few goods".
Second, both stagnation and inflation can result from inappropriate
macroeconomic policies. For example, central banks can cause inflation by
permitting excessive growth of the money supply and the government can cause
stagnation by excessive regulation of goods markets and labour markets. Either
of these factors can cause stagflation. Excessive growth of the money supply
taken to such an extreme that it must be reversed abruptly can clearly be a
cause. Both types of explanations are offered in analyses of the global
stagflation of the 1970s: it began with a huge rise in oil prices, but then
continued as central banks used excessively stimulative monetary policy to
counteract the resulting recession, causing a runaway price/wage spiral.
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