Stagflation: what is it – Dictionary of Economics

Definition of Stagflation

Stagflation is an economic concept that implies the acceleration of inflation coexisting with high unemployment rates. The term was coined in 1965 by the then British finance minister, Ian McLeod as a fusion of the words stagnation and inflation in a speech 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. We have a sort of ‘stagflation’ situation” another. We have something like a stable).

Causes and consequences of stagflation

Formally, a recession is determined when the Gross Domestic Product (GDP) decreases for two consecutive quarters. When the recession is accompanied by high inflation, the process is called stagflation; it is considered one of the worst possible economic scenarios due to the difficulty of handling and correcting it. The monetary and fiscal policies that are usually used to revitalize a recessive economy worsen the inflationary component of stagflation, and the restrictive monetary policies that are used to combat inflation tend to deepen and widen its recessive component.

Stagflation completely distorts markets and puts government policy makers and their central banks in a ‘lose-lose’ position. In stagflation, the recession is usually partial, simultaneously registering the decrease of some sectors, such as the production of goods, together with the growth of other sectors, such as the production of services. If it is a relatively open economy and inflation is accompanied by a devaluation process, there may be a contraction of activities that consume foreign currency and an expansion of those that generate foreign currency. This represents an enormous challenge for the authorities as they receive mixed and contradictory signals about the economy that make it very difficult to decide which policies to apply, in what sequence and when to take them. “It’s the worst of both worlds” say many economists.

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Historical evolution

Traditionally, and especially after the apparent triumph of the Keynesian Theories after the , it was accepted that the economy of a country could be affected by two major problems: on the one hand, recession, represented by negative growth rates and a high unemployment rate. On the other hand, inflation, the upward and unlimited spiral of prices, with what it meant for the real impoverishment of broad social layers and the difficulty in the correct allocation of resources in business processes.

These two problems were considered incompatible. They could not coexist within the accepted economic model. And the solutions seemed clear, both from the point of view of monetary and fiscal policy. For inflation, rise in interest rates and greater fiscal pressure and/or reduction in public spending. For the recession just the opposite.

However, starting in the second half of the 1960s, it began to be perceived that a new phenomenon was taking over the economy. At the same time, low or even negative growth rates coincided with strong inflation. McLeod, UK Chancellor of the Exchequer, called it stagflation, and Milton Friedman was one of the few economists who warned that classical solutions were doomed to fail. If policies were used to contract the money supply and to reduce public spending, the aspect of unemployment and recession worsened, with the consequent social pressure. If, on the contrary, a policy of increasing public spending and low rates was adopted, inflation would skyrocket, deepening stagflation and increasing the number of future unemployed.

Stagflation becomes a dilemma for monetary policy, which must choose between measures normally used to increase economic growth and thereby increase runaway inflation, or anti-inflation policies that reduce activity in a stalled economy. Normally, central banks must choose between reactivating the economy or draining it by adjusting the interest rate of money, this being their main task. Reducing the interest rate causes economic growth but this triggers inflation, increasing the interest rate fights inflation but reduces economic growth. In stagflation it is said that both problems coexist.

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Part of the difficulty central banks face in stagflation is that it occurs selectively across asset classes. For example, in late 2007, US home values ​​began to fall (deflation) while consumer prices began to rise (inflation). The efforts of the Federal Reserve (say the US Central Bank) to prevent the fall in housing prices were aimed at reducing the interest rate to make mortgages more affordable. This caused consumers to have more money available by reducing credit prices.

How to deal with stagflation?

In short, the fight against stagflation must be carried out within the framework of an integrated strategy that brings together important and necessary economic policy measures to combat inflation with unemployment, such as a mixed fiscal and monetary policy that acts in a coordinated manner and taking into account Collateral damage; a supplementary incomes policy that is essentially essential if the need to adjust real wages to inflation is accepted; measures to reduce adjustment costs or information costs in the labor market, as well as microeconomic reforms to improve the efficiency of these markets; regional policies that mainly try to fight against the growing level of dispersion of unemployment, given that this constitutes an important inflationary factor; measures consisting of structural and institutional changes and measures that lastingly restore the pace of productivity growth.

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