What causes stagflation?
When an economy is experiencing large amounts of inflation and low growth, it is experiencing a phenomenon known as “stagflation.” To depict this graphically, below is a simple stagflation graph used in economics classes. We see that the short-run aggregate supply (SRAS) curve has shifted to the left, thus depicting an increase in the price level (inflation) and a decrease in real GDP.
The primary root cause of stagflation is widely debated among economists; however, most agree that a sharp rise in the prices of essential resources, such as oil, labor, or food, contributes greatly to stagflation. For example, due to the 1973 Arab-Israeli War, the Organization of Oil Producing Nations (OPEC) placed an oil embargo on the United States, thus contributing to stagflation in the nation throughout the 1970s. Furthermore, stagflation can also occur if workers unionize and demand greater wages, thus increasing costs for labor. A rise in supply chain costs in an economy can also contribute to stagflation. In 2020 and 2021, due to the COVID-19 epidemic and the subsequent lockdowns, supply chains worldwide were hindered thus contributing to stagflation in many countries. Later COVID-19 lockdowns in China and the 2022 Russian invasion of Ukraine increased the costs of many resources including metals, semiconductors, and chemicals. The subsequent stagflation due to supply chain shortages increased stagflation globally.
What happens during stagflation?
During stagflation, not only does an economy stagnate, but it also faces high unemployment and greater living costs, thus increasing private and public debt. It can cause everything from individuals to governments to default on their debt. The effects of stagflation can last for years, causing immense economic turmoil. Stagflation is seen as a more damaging economic cycle than a recessionary or an inflationary period. This is because stagflation consists of all of the symptoms of a recession but with high inflation.
How is stagflation resolved?
Unlike with other economic cycles, there is no easy remedy for stagflation. A nation can either increase economic growth by decreasing its interest rates or decrease inflation by increasing interest rates; thus, a balance in monetary policy must be found in curbing stagflation. A government can attempt to increase economic growth amid stagflation by reducing taxes and increasing spending; however, this may end up increasing the already high inflation. Thus, a balance in fiscal policy must also be found. Typically, nations deal with inflation before they deal with unemployment because inflation is a more volatile issue. They do this by using contractionary fiscal policy (higher taxes, lower spending) or contractionary monetary policy (increasing interest rates, selling government bonds). Monetary policy is used more because it is more effective in curbing inflation.
However, as the worst cases of stagflation have historically been caused by a rise in the prices of oil, a nation can try to avoid the problem of stagflation in the first place by decreasing oil dependence. This can be done via government programs promoting alternate sources of energy.
As an example of the recovery process of stagflation, when stagflation is caused by an increase in the price of oil, the course of action for a nation is to treat the symptoms of stagflation while waiting for the price of oil to go back to normal. Banks increase their interest rates to curb the inflation during the time.
We must understand stagflation, as it is the most damaging of the economic cycles. Its impacts can last for many years. Even though stagflation may scare all of us, with increased prices, negative growth, and little that can be done for it, we can understand the ways we can “treat” it while our economy goes back to normal.
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