Stagflation – Definition and Effects on the Economy

Stagflation in a country is the combination of inflation and economic stagnation. This phenomenon unites these two concepts, which when they occur at the same time are devastating for the economy.

In other words, stagflation arises when a country’s economy is stagnant, that is, it does not grow and, at the same time, the cost of living rises, motivated by high inflation. This combination causes the impoverishment of the population.

Its origin dates back to the speech in front of the House of Commons given in 1965 by the then British finance minister, Ian McLeod.

The senior official assured that the United Kingdom was in a kind of “stagflation”, combining the words inflation (inflation) and stagnation (stagnation).

Definition of stagnation

This is how in a situation of stagflation, a country suffers from the stagnation of its economy while the cost of the basic basket rises.

It is a very complicated scenario where situations of rising prices, rising unemployment, and economic stagnation overlap. This can lead the country to a very serious circumstance of impoverishment.

Characteristics of stagflation

In essence, the characteristics that tell us what stagflation is are the following:

  • There is high inflation, as well as high unemployment and a moderate, stagnant, or even negative growth rate in the economy.
  • Usually, it causes the economic impoverishment of the territory that suffers it.
  • Stagnation causes the impoverishment of the inhabitants, which in turn reduces demand and therefore further worsens economic stagnation, producing a snowball effect.
  • Stagflation seriously affects (more than other phenomena) the growth of the different productive sectors.
  • It is usually preceded by shocks that generate imbalances in the markets, between supply and demand.
  • It is a recent concept, so experts continue to investigate its causes, consequences, as well as mechanisms to solve scenarios of this type.

How do we know if a country is in or is experiencing stagflation?

On the one hand, the stagnation of the economy, the high unemployment rate, and high inflation distinguish stagflation. Well, the lack of dynamism in the economy is accompanied by an upward spiral in prices. This increase mainly impoverishes the middle and lower strata of society, while making it difficult to allocate resources to business projects.

Until the mid-1960s, these two serious macroeconomic problems, stagnation, and inflation were believed to be incompatible with each other. Namely:

  • When there was economic stagnation there was usually no inflation (and even deflation).
  • And vice versa, when there was high inflation it was usually accompanied by strong economic growth.

And stagflation was therefore an extraordinary event since it combines the two drawbacks at once: stagnation and inflation.

Why does stagflation occur?

According to the 1970 Nobel Laureate in Economics Paul Samuelson, stagflation is a phenomenon “typical of mixed economies due to various factors, where societies generate institutional mechanisms such as unemployment benefits, minimum wages, labor market segmentation, among others, that make the economy react differently from theory.”

The economic programs that have given the best results to combat this phenomenon are labor flexibility, incentive business taxation, less rigid and intervened commercial distribution, defense of competition, education, and training linked to the productive apparatus, among other macroeconomic measures.

Consequences of stagflation

That said, it is important to highlight some of the consequences of stagflation.

Among these, the following should be highlighted:

  • The consequences of stagflation, given that we are talking about stagnation and inflation, are the same as those that these two phenomena have separately, but aggravated by the coexistence of these two unpleasant phenomena.
  • In this sense, stagnation produces high unemployment, while the gross domestic product (GDP) falls.
  • Family incomes are reduced by the deterioration experienced by wages, while others become unemployed and no longer have income.
  • Inflation, on the other hand, adds the general rise in prices to the situation of scarcity of resources, which exacerbates this scarcity.
  • In this way, citizens have less purchasing power, since not only do they earn less money, but they can also acquire less due to inflation and the rise that this entails.
  • Regarding the recovery of the economy, the process is very slow, since a large percentage of companies are stagnant while resuming their production levels is a very complicated process due to the consequences of the inflation itself that accompanies this previous situation.

In short, they are the very consequences of economic stagnation (high unemployment, stagnant production, etc.), but aggravated by a high cost derived from inflation.

Stagflation effects in the economy

How to combat stagflation?

When we talk about stagflation, we must know that we are talking about a situation that is not at all desirable and is highly feared by economists. So we could say that we would be facing one of the worst economic scenarios, since managing stagflation and correcting it is a very complicated task.

This is because the expansionary monetary and fiscal policies used to stimulate a stagnant economy, in turn, tend to generate more inflation.

In the same way, restrictive monetary policies, which are those used to combat and curb inflation, tend to reduce the growth of these already stagnant economies.

Therefore, it is very difficult to control a situation that even John Maynard Keynes himself, being the most influential economist of the 20th century, could not foresee. Well, it should be noted that his theory of aggregate demand contemplated that unemployment and inflation were two concepts that could never coexist in an economy at the same time.

However, despite all the progress the economy has made, economists continue to fear stagflation. Especially, due to the impossibility of combating the two phenomena (stagnation and inflation) simultaneously with conventional economic policy strategies.

Example of stagflation: 1973 oil crisis

The best example to explain what stagflation is is the 1973 oil crisis.

The crisis began with the restrictions of the Organization of Petroleum Exporting Countries (OPEC), which caused oil to be stopped exporting to countries such as the United States, as well as other countries in Western Europe.

These restrictions led to an increase in the price of oil and, as a consequence, what is known as “cost inflation” occurred. That is, an increase in production costs.

These costs ended up reaching consumer products, while the economy was stagnant.

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