You have, probably, already heard of economic inflation and deflation. And you know that the first one is characterized by a growing economic output, less unemployment and price levels going up. While deflation is the exact opposite. But what about a combination of both, sounds weird right? but yes, there is something called Stagflation !
As you may notice, the word stagflation is a combination of “Stagnation ” and “Inflation “. And this is in line with the definition of this phenomenon that says: stagflation is a situation in which the economy experiences low economic growth (low GDP) and high unemployment rate on one hand, and high price levels on the other hand. In other words, a simultaneous increase of inflation and stagnation of economic output.
This phenomenon is generally due to a “supply shock ” which means that the supply suddenly goes down dramatically, and this causes an increase in prices that, in its turn, leads to decreasing demand, decreasing demand means investment rate will go down and the unemployment will rise. The decrease in investment also means low economic output and GDP. And this is how a supply shock leads the economy to stagflation .
Stagflation was first noticed in the 70s of the last century and it was caused by the oil embargo at that time.
In November 1979, the price per barrel of West Texas Intermediate crude oil surpassed $100 and peaked at $125 the following April . That price level would not be exceeded for 28 years.
Back then many developed economies experienced rapid inflation and high unemployment as a result of this oil shock.
And since then, rising price levels during periods of slow or negative economic growth have become somewhat of the norm rather than an exceptional situation.
The economic theories that used to dominate back then never expected a such situation, they portrayed macroeconomic policy as a trade-off between unemployment and inflation.
How to cure stagflation?
Finding a solution to control an economy in stagflation is a situation that none would like to be in.
The usual monetary and fiscal policies don’t seem very effective. These policies can help in reducing inflation OR increasing the economic but they can not solve the both problems at the same time.
So we need other alternatives.
. Wage and prices control: the government should intervene to limit wage rises to break the cycle of wage inflation
Wage and price control policies eliminate inflation at the cost of much higher unemployment than that which would have resulted under a stable currency regime.
. Philips curve: some keynesian economists suggested to monitor the trade-off between unemployment and inflation and keep the business cycle in balance .
. Supply side policies: considered as probably the most effective solution to stagflation, consists of increasing the aggregate supply to reduce costs of production and this will lead to a decrease in prices and promote economic growth at the same time.
Self-correction: some other economists argue that stagflation may self-correct in time in the absence of any intervention.