Stagflation: Definition, Causes & Consequences

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Stagflation: Definition, Causes & Consequences

Table of Сontents

  1. What Is Stagflation?
  2. Stagflation in 2022
  3. What Causes Stagflation?
  4. A consequence of Economic Stagflation
  5. 1970s Stagflation Example
  6. Responses to Stagflation
  7. Hedging Against Inflation
  8. Bottom Line

Stagflation is a condition that occurs in the economy when there are periods of time in which there is significant inflation, very little or no growth, and high unemployment. Before the 1970s, the economic theories that were prevalent claimed that inflation virtually always grew when the unemployment rate was low and fell when the unemployment rate was high. However, these beliefs were proven wrong in the 1970s. Since then, economists have been forced to make improvements to their economic theories.


What Is Stagflation?

The phrase “stagflation” refers to a situation in which an economy is characterized by considerable inflation, high unemployment, and sluggish or negative economic growth. This phrase is a portmanteau that was created by combining the phrases inflation and stagnation in GDP.

During the 1970s and 1980s, most of the world’s major economies experienced prolonged bouts of stagflation. Economists were taken aback by this finding since the Keynesian macroeconomic theory, which was the preeminent school of economic thought at the time, postulated that rises in inflation and unemployment couldn’t occur at the same time.

The Phillips Curve was an economic model that was used to suggest that there was an inverse link between unemployment and inflation. This was partially based on the Phillips Curve. Since then, economists have identified a large number of possible causes that impact stagflation, including a rapid shock to the supply of goods and damaging policies enacted by the government.

Note that stagflation was a significant issue in the 1970s and again in the 1980s, but that it has not been a concern in more recent years. This is because the oil crisis occurred during those decades. It has been a priority for governments and central banks to coordinate their efforts in order to monitor and act in order to control inflation without causing a drop in economic production and to avoid measures that are likely to favor stagflation.


Stagflation in 2022

Since the previous year witnessed a sharp rebound in consumer demand in addition to significant supply chain issues that have driven price increases, some economists were concerned that the United States could see signs of stagflation in 2022. This is because the previous year saw a combination of both factors. The invasion of Ukraine by Russia also contributed to a rise in the price of gasoline, which occurred at the same time that the Federal Reserve began its campaign to raise interest rates. The effect of stagflation is that it may generate rising drops in GDP, which can lead to a recession if it continues for an extended period of time.

What Causes Stagflation?

The Phillips Curve supported the theory that unemployment and inflation were inversely linked, so economic theory prevalent before the stagflation-fueled 1970s didn’t believe that it was possible for stagflation to occur. As a result, the causes of stagflation are a contentious topic of discussion among economists. Nevertheless, economists have put out a variety of explanations as to what exactly causes stagflation.

1. Supply Shock

According to the supply shock hypothesis, stagflation happens when there is an unexpected drop in the amount of a service or commodity that is available for purchase. This leads to a significant rise in prices, which, in turn, often results in a reduction in profit margins for the majority of businesses and slows economic development.

2. Bad Monetary Policies

According to the notion of poor economic policy, stagflation is often the outcome of economic policies that are ineffective. When the government and the central bank try to manage the economy, they often end up making decisions that aren’t in the best interest of the economy. For instance, prior to the 1970s, the United States government was intent on achieving maximum employment across the entire economy in response to the Employment Act of 1946. However, this policy unintentionally led to an increase in inflation, which in turn had a negative impact on employment and growth.

The Nixon Shock was a tactic used by Richard Nixon that included depreciating the dollar and establishing wage and price freezes. This approach was known as the Nixon Shock. Government policies that regulate the economy may also have an influence. In the end, central banks and lawmakers struggle with the question of how to combat stagflation due to the fact that interventions to promote their goals of price stability, low unemployment, and economic growth might clash with one another.


3. Differential Accumulation

The differential accumulation explanation of stagflation is a hypothesis that was developed by economists Jonathan Nitzan and Shimshon Bichler. This explanation of stagflation proposes that there is a connection between mergers and acquisitions, stagflation, and globalization. They hypothesize, in a manner that is analogous to the supply shock theory, that differential accumulation is the driving force behind mergers and acquisitions, which then concentrate the power to limit the supply of commodities and accumulated capital in fewer hands, which in turn increases the likelihood of stagflation.

4. Demand-Pull

The demand-pull stagflation hypothesis was first proposed by the economist Eduardo Loyo. This theory implies that stagflation may arise only as a result of monetary shocks and does not need the presence of a supply-related shock. This happens when governments implement monetary tightening policies such as increasing the federal interest rate or reducing the money supply. Another example of this would be a drop in the amount of currency in circulation.

5. Cost-Push

The cost-push inflation hypothesis identifies supply-side inflation as a fundamental cause of stagflation. In this situation, increasing prices contribute to unemployment because they generally diminish profit margins for enterprises which leads to reduced economic production. Supply-side inflation may also be influenced by factors like tariffs, increases in salaries, or labor shortages.

6. End of the Gold Standard

It is believed that one factor that contributed to the stagflation that occurred throughout the 1970s was President Nixon’s decision to stop the convertibility of United States dollars into gold. This action led to the collapse of the Bretton Woods System. Because there were more dollars held in foreign hands than there were gold reserves in the United States, the gold standard left the United States susceptible to runs on gold. In 1971, President Nixon put an end to the practice of exchanging dollars for gold and shut down the “gold window.” The value of the United States Dollar was formally uncoupled from the value of gold in the year 1976. Both of these actions resulted in a devaluation of the dollar, which had a negative influence on both inflation and economic growth, ultimately leading to stagflation.

The takeaway here is that economists do not all agree on what factors lead to stagflation. It is still the subject of vigorous discussion. However, the majority of people think stagflation is a problem.


A consequence of Economic Stagflation

What kinds of difficulties do average people face as a result of stagflation? When stagflation develops, it has a direct influence on affordability, making it more difficult for many people to satisfy their fundamental necessities. This is particularly true for those who are jobless and part of the labor force that is underemployed. Stagflation might result in risks of job loss and lower earnings for those who are already working, which would result in a decline in consumer confidence and spending power.

Stagflation is problematic for investors as well. Stagflation often results in decreased profit margins for businesses as a direct consequence of rising raw costs and decreased sales. According to research published by Goldman Sachs, this has an effect on the stock market since the S&P 500 index has generated an average return of 2.5% every quarter over the last 60 years but has generated an average return of -2.1% during periods of stagflation historically. Investors may be directly affected by stagflation since it slows the development of firms’ profits per share, which in turn has an effect on the price of stocks.

Investors in dividends might potentially be badly impacted if businesses cut or eliminate their dividend payments in an effort to preserve cash. There is a possibility of big losses for those people who invest in growth companies due to the fact that many investors may have anticipated growth objectives that would be tougher to reach as a result of stagflation.

If stagflation continues for an extended period of time, it is possible that some businesses could fail, resulting in severe financial losses for investors. The incapacity of firms to repay their obligations would almost certainly have an impact on the values of bonds. Nevertheless, there are hedging strategies that investors may use to protect themselves from the danger of inflation, such as investing in funds that are created particularly to sail through times of high inflation.

Investors who are concerned about the impact that stagflation will have on their portfolios may want to reconsider their investment strategy or choose to maintain their holdings in blue chip stocks within staple industries that generate consistent earnings and are likely to weather the effects of stagflation or recover quickly after its onset.

It is possible that stagflation will have an effect on worldwide commerce by driving up the price of all global commodities, including food, so making it much more costly to do business and escalating inflation even more. Because of the interrelated nature of global commerce, national or global unemployment may also have the effect of lowering economic production, consumer confidence, and consumer spending throughout the world. This can lead to an increase in the overall rate of unemployment.

As a result of the fact that various policies provide varying circumstances for recovery, which may be in conflict with one another, diverse national policies designed to combat stagflation may also have an effect on global commerce. Most of the time, this has a greater impact on economies that are still in the process of emerging or developing because many of these countries lack the capacity to implement the kinds of monetary or stimulus policies that other nations use to combat stagflation because their deficit-to-GDP ratios are so high.


1970s Stagflation Example

The oil crisis of the 1970s is the instance that is most often used to illustrate stagflation. In October 1973, in reaction to Western support for Israel during the Yom Kippur War, the Organization of the Petroleum Exporting Countries (OPEC) established an oil shipping embargo against the United States of America and Israel’s European allies. This embargo lasted until 1974.

The restriction on oil production produced an instantaneous surge in oil prices of more than 300 per cent. This resulted in significant problems in the United States, which is heavily reliant on automobiles and where the price of oil remained high long after the embargo was lifted in March 1974. This occurred at the same time that manufacturing jobs were being moved outside of the United States in order to save on labor costs and the rising cost of the Vietnam war. This resulted in a prolonged period of stagflation, a condition in which elevated oil prices caused inflation to rapidly rise, unemployment to increase, and the economy to stagnate.

As a result of the shift in the economy of the United States away from manufacturing and toward employment in the service sector that pays less, real wages have stopped increasing, which has led to a reduction in consumer confidence and lower spending, which has further exacerbated the problem.

Richard Nixon, who was president during the 1970s, attempted to reduce the effects of stagflation by depreciating the currency and instituting price and pay controls. However, that tactic did not prove to be successful, and Jeremy Siegel, a notable economist, now considers it to be one of the worst disasters of American macroeconomic policy. Many economists today hold the view that the expansion of the money supply in the 1970s brought on by the Federal Reserve was the primary contributor to the stagflation disaster that occurred during that decade.

Throughout that time period, there was a widespread misconception that high inflation was correlated with low unemployment. However, during the 1970s, both unemployment and inflation rates continued to climb. To put an end to stagflation, it was important to adjust economic policy such that the primary emphasis was on maintaining low unemployment rates and stable prices.

Takeaway: There are some economists who are of the opinion that the oil embargo and oil shortages were not the fundamental factors that led to stagflation in the 1970s.


Responses to Stagflation

Targeting one part of the issue might have a detrimental influence on another aspect of the problem, making it difficult for central banks and policymakers to formulate an appropriate response to inflation. For instance, rising interest rates results in an increase in the cost of borrowing money and a reduction in demand, both of which have the effect of lowering inflation but also result in a slower growth rate for GDP.

Monetarist Responses

A reduction in inflation would be the monetarist answer to stagflation. This approach would be implemented even if it resulted in an increase in unemployment and a slowdown in economic development in the near term. A recession followed the implementation of this plan by the Conservative administration that was in power in the United Kingdom from 1979 to 1984.

Supply-Side Responses

As a potential solution to the problem of cost-push inflation, increasing aggregate supply via policies like deregulation and tariff suspension that are intended to encourage businesses in their efforts to lower costs and boost efficiency may be a viable option. However, since these initiatives are national policies, they are often disregarded because they are intended to solve global supply problems.

Wage Control Responses

If it is determined that increasing wages are the root cause of stagflation, then pay regulation might be adopted to slow the rate of wage increases that are contributing to price inflation and narrowing profit margins.

Neoclassical Responses

The Austrian economist Friedrich Hayek argued that governments combat inflation by withdrawing their support for expansionary monetary policy and instead allowing the free market to determine how prices should be set. This necessitates limiting actions like increases in the money supply and decreases in interest rates, among other things.

Waiting Responses

Many economists are of the opinion that doing nothing may be the most effective course of action when confronted with stagflation. Stagflation may occasionally be overcome with the passage of time, and attempts to overcome it through interventions might result in recessions with significant drops in GDP.

Hedging Against Inflation

Investors who are concerned about the impact that stagflation will have on their portfolios may want to reconsider their investment strategy or choose to maintain their holdings in blue chip stocks within staple industries that generate consistent earnings and are likely to weather the effects of stagflation or recover quickly after its onset.

There are other ways that investors might hedge the risk of inflation, such as investing in funds that are expressly built to manage times of high inflation. One of these strategies is to invest in index funds. Long-term investors would be prudent to keep their portfolios diversified, continue dollar-cost averaging, and rebalance their holdings on a regular basis since they are best practices for investing in any market or economic climate.


Bottom Line

Economists have spent a lot of time trying to figure out what exactly causes stagflation and how they can best respond to it when it occurs. Even though there are many different hypotheses, they are all hotly debated. The issue of stagflation is a complex one to solve, which makes it difficult for central banks and governments to react in an effective manner.


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