Stagflation is a macroeconomic phenomenon. It is an amalgamation of the words “stagnant” and “inflation”, which is a reflection of its meaning. Economists use this term to describe an economy that is suffering from low growth, high unemployment, and high inflation.

Clearly, this is a very undesirable economic state. Low growth and high unemployment mean that there are few opportunities for people to become employed or seek better jobs, while high inflation continually erodes the value of people’s money over time. This can spiral an economy into a recession situation complicated by the fact that promoting growth to end the recession will make inflation, and people’s financial situations, even worse.

The term “stagflation” was popularized in the 1970s (although its first use came as early as 1965), reflecting similar economic situations in the United Kingdom and United States. This was the first time in modern economic history that stagflation had occurred, taking economists and policy makers by surprise. Several factors contributed to its onset.

One commonly cited factor is an oil trade embargo from OPEC countries that began in 1973 and caused energy prices to rise sharply, creating a feedback effect that increased the prices of many other goods. This is an example of a supply shock. In this case it contributed to high inflation, which reached 18.0% in the UK and 13.5% in the US in 1980.

However, other factors had already started developing stagflationary pressures before the oil embargo. In the US, the federal government had a high budget deficit following the Vietnam War, but the government was unwilling to raise taxes to eliminate the deficit. In addition, the Federal Reserve was focused on promoting economic growth to combat unemployment and the multiple recessions that occurred in the 1970s, which meant that interest rates were kept low throughout the decade. Low interest rates disincentivize saving and encourage spending, which contributes to growth - but also inflationary pressure.

In the U.K., it is often argued that policymakers did not appreciate the role that monetary policy could play in controlling inflation. This was despite the warnings of Iain MacLeod, who is sometimes credited with coining the term stagflation. He warned Parliament in 1965 of the dangers of simultaneous high inflation and unemployment, which the economy was even then trending towards.

Regardless of the factors contributing to stagflation, politicians and economists were caught off guard. This was partly due to the fact that many of them believed unemployment and inflation shared an inverse relationship, a belief reflected in the Philips Curve. This economic moment proved that the Philips Curve was not a true, stable relationship, but had been just a circumstance during the decades prior.

To deal with stagflation, typically a country needs to reduce the amount of spending in the economy (i.e., reduce the velocity of money) to allow inflationary pressures to ease up. A central bank can encourage this by raising interest rates. Higher interest rates, ceteris paribus, incentivize people to spend less and save more. This is because savings grow more quickly with a higher interest rate, while the opportunity cost of holding cash is greater as it is devalued faster.

This is partly how the U.S. was able to stave off stagflation in the early 1980’s. The Chair of the Federal Reserve at the time, Paul Volcker, became heavily unpopular after he raised interest rates in the midst of the economic struggle. He also tightened the money supply to reduce inflation more directly, by “restraining growth in money and credit”. However, these unpopular moves were ultimately successful, and by the end of his appointment Volcker’s policies had led to a sustainable drop in the inflation level. Unemployment soon fell as well, and the economy was primed for excellent growth after 1982.

Good to Know

This first major period of stagflation was a boon to the ideas of Milton Friedman and the monetarist school of thought. Monetarism states that money is non-neutral in the economy and must be managed well, in opposition to Keynesian ideas that money is just a nominal tool and doesn’t affect the economy on its own.

These once-dominant Keynesian ideas were proved lacking after stagflation. However, Keynesian economists learned from stagflation and updated their models - as economists often do when challenged by new evidence. This led to the formation of the New Keynesian school of thought, an evolution of the old Keynesian ideas but updated for the modern era.

References 

Bryan, M. (n.d.). The Great Inflation. Federal Reserve History. Retrieved July 6, 2022, from https://www.federalreservehistory.org/essays/great-inflation.