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What is Stagflation?

written by: Kantha Wijeratne•edited by: Jean Scheid•updated: 9/15/2009

Stagflation refers to an unfavorable economic trend that causes hardship to individuals and businesses. This article describes the reasons that lead to stagflation and how it is corrected. It also suggests ways we can cope in a period of stagflation.

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    Stagflation is an economic trend that arises from increases in inflation and unemployment happening at the same time. It leads to a slowing down of economic activity. The word “stagflation” combines two words, economic stagnation and inflation. It was coined by Iain Macleod, a member of the British Conservative Party in a speech made in November, 1965 to describe the prevailing economic situation in Britain. Since then, countries around the world have experienced stagflation in varying degrees.

    Stagflation creates much economic hardship. How is it caused? How do governments correct this situation? How do we cope in a situation of stagflation?

    An economy is understood to be stagnant if it experiences a long-term period of economic growth that is less than 2-3%. Inflation is defined as a general increase in the price of all goods and services as measured by the Consumer Price Index.

    Governments employ a mix of fiscal and monetary policies to correct unfavorable economic trends and to foster growth. Reducing the Fed funds rate leads to a lowering of interest rates by banks that promotes borrowing and more economic activity. The increased money supply can also fuel inflation. On the other hand, increasing the Fed funds rate leads to a contraction of the economy. This results in lowering inflation but also slows down the economy. When stagflation happens there is both inflation and reduced economic activity. Policymakers are challenged to implement actions that simultaneously address both these issues.

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    What Causes Stagflation?

    There are two main reasons that are believed to cause stagflation. The first relates to a sudden and unexpected rise in the price of a commodity, such as the oil price shocks experienced in the US in the 1970s. This leads to a general rise in production costs leading to price increases. As the purchasing power of the currency decreases, people cannot afford the cost of some goods and services. They limit their purchases to meeting basic needs. Businesses respond by scaling back. This leads to increased unemployment and a slowing down of the economy. The result is stagflation.

    Stagflation is also cited to result when governments implement macroeconomic policies that are not suitable. Excessive regulations can curb economic growth. Expansionary policies that are used to correct such situations can lead to inflation and increased unemployment. The economy slows down resulting in stagflation.

    In addition to fiscal and monetary factors, factors such as labor market conditions and strength of trade unions, international events, expectations people have about inflation and supply constraints can also distort costs and prices within an economy leading to increased inflation that can ultimately lead to stagflation

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    How is Stagflation Corrected?

    According to Keynesian theory, inflation and economic stagnation cannot happen simultaneously. Using monetary policy to control one factor, say inflation, can lead to further economic woes.

    Countries around the world have tried different methods to tackle stagflation. Based on such experiences, it is seen that there is usually a time lag before an economy turns around. The intervening period is marked with increased business bankruptcies and hardship to the public at large.

    Policymakers use a combination of fiscal and monetary policies to control stagflation. While increased spending by the government or reduced taxes stimulate growth, monetary policies are used to manage liquidity in the system and to control inflation. Governments also aim to stabilize key institutions so as to retain public confidence in their operations.

    Measures to reduce costs, such as more efficient design of processes and machinery as well as alternative technologies and conservation of resources can also contribute favorably to reverse stagflation.

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    How Do We Respond to Stagflation?

    Stagflation leads to a drop in consumer confidence and uncertainty about how long this condition would last. Our best response as consumers is to make wiser decisions about budgeting and investing.

    Financial experts advice us to maintain an emergency fund of 3-6 months of living expenses at all times. This advice is even more relevant in a slow economy. Even if funds are available, consider carefully before purchasing high value items or a second home. Stagflation increases the risk of job loss. So use every opportunity to sharpen job skills. Ensure that credit card or other high-interest bearing debt is under control. Paying down credit cards and maintaining about two cards is a wise move.

    In summary, stagflation is caused by macroeconomic events that are not within our control. The interim period before the situation is corrected can call for sacrifices on the part of consumers. Careful planning in both spending and investing can help us see through such downturns.