How Does Stagflation Occur? A Review of Its Causes

Stagflation represents a challenging economic situation marked by the unusual combination of high inflation, slow or stagnant economic growth, and elevated unemployment. This phenomenon contrasts with conventional economic understanding, where inflation often accompanies robust growth and low unemployment. It presents a difficult dilemma for policymakers, as traditional tools used to address one issue can often worsen another.

The term “stagflation” gained widespread recognition during the 1970s, when major economies, including the United States, grappled with these simultaneous economic problems. This period led to a reevaluation of established economic theories, as prevailing models did not adequately explain the coexistence of rising prices and economic stagnation.

Unusual Economic Conditions of Stagflation

Stagflation is defined by the simultaneous presence of three distinct and contradictory economic conditions: high inflation, high unemployment, and slow economic growth. High inflation means the general price level of goods and services is rising significantly, leading to a decline in purchasing power, affecting consumers’ ability to afford necessities and businesses’ operational costs.

High unemployment signifies that a substantial portion of the workforce is unable to find jobs, contributing to reduced overall production and consumer spending. Slow or stagnant economic growth refers to a period where the nation’s total output of goods and services (GDP) grows very little or even contracts.

The combination of these factors is unusual because, in many economic models, inflation and unemployment have an inverse relationship, often described by the Phillips Curve. Traditionally, reducing unemployment might lead to higher inflation, and curbing inflation might increase unemployment. Stagflation defies this conventional trade-off, presenting a scenario where an economy experiences the worst of both worlds.

Role of Supply Shocks

Significant disruptions to the supply side of the economy, known as supply shocks, play a key role in triggering stagflation. These shocks involve an unexpected decrease in essential goods or a sharp increase in the cost of crucial production inputs. Businesses then face higher expenses to produce their goods and services.

A classic example involves sharp increases in commodity prices, such as oil. If energy costs suddenly rise, it becomes more expensive to manufacture products, transport goods, and power businesses. This increased production cost translates into higher prices for consumers, fueling inflation.

Beyond higher prices, these supply shocks also hinder economic growth and can lead to job losses. Faced with elevated operating costs, businesses may reduce production levels or postpone expansion plans, which can result in a slowdown in overall economic output. Some businesses might also cut their workforce to manage expenses, contributing to an increase in unemployment.

Impact of Macroeconomic Policies

Macroeconomic policies, specifically monetary and fiscal actions, can inadvertently contribute to stagflation. Monetary policy, controlled by a central bank, manages the money supply and credit conditions. An overly expansionary monetary policy, such as creating too much money or keeping interest rates too low, injects excessive liquidity into the economy. This can lead to persistent inflationary pressures, especially if not matched by increased productive capacity.

If a central bank attempts to stimulate growth or reduce unemployment without addressing supply constraints, increased money chasing limited goods drives up prices further, embedding inflation. Conversely, fiscal policy, involving government spending and taxation, also plays a part. Large, sustained government budget deficits, especially if financed by borrowing that competes with private investment or expands the money supply without corresponding economic output, can contribute to inflationary pressures.

Inefficient government spending may not boost productive capacity or create substantial employment, even as it adds to demand and potential for inflation. This can cause prices to rise without improving economic growth or employment, exacerbating stagflation. The challenge for policymakers is finding a balance, as traditional responses to inflation might slow growth, while responses to stagnation might fuel inflation.

Influence of Economic Expectations

Economic expectations play a significant, self-fulfilling role in the development and persistence of stagflation. When individuals and businesses anticipate future price increases, their current behaviors reinforce inflationary trends. For instance, workers expecting inflation to erode purchasing power demand higher wages.

As labor costs are a substantial expense, higher wage demands compel companies to increase prices to maintain profitability. This creates a “wage-price spiral,” where rising wages lead to rising prices, fueling demands for even higher wages. This cycle can become deeply embedded, making inflation difficult to control.

Expectations about future economic conditions also influence business investment and hiring. If businesses anticipate continued stagnation or uncertainty, they may hesitate to invest in new projects, expand operations, or hire staff. This caution leads to reduced capital formation and slower job creation, contributing to stagnant growth and higher unemployment.