What was a key factor of stagflation

Inflation often goes hand in hand with economic growth as consumers are willing and able to pay more for goods and services. What happens when inflation occurs during times of economic stagnation? The answer is stagflation, and it’s never good news. What is stagflation exactly, and what is its meaning in economics? We’ll explore these questions below.

Stagflation definition: what is stagflation?

As the name suggests, the stagflation meaning combines two concepts: stagnation and inflation. This economic phenomenon takes place when economic growth rates stall (or stagnate) and both unemployment and inflation rates are high.

Normally, slow economic growth prevents inflation according to the rules of supply and demand. As consumer demand drops, prices fall accordingly. This makes stagflation a rather unusual economic event, caused by disruptive government policies interfering in usual market function. It can be a real problem for governments to solve because most interventions designed to reduce inflation will raise unemployment and vice versa.

Stagflation meaning in economics

We can gain a greater understanding of the stagflation meaning in economics by looking at when the term was first used. The stagflation definition was first hinted at in the 1960s by British politician Iain Macleod when describing the economy as a ‘stagnation situation’.

However, stagflation is most associated with the 1970s recession, when the U.S. experienced five quarters of negative GDP growth after the oil crisis. During this time, inflation doubled in 1973 before heading into the double-digit figures in 1974, coinciding with a 9% unemployment rate in 1975.

This went against prominent economic theories of the time, particularly the ideas in macroeconomics based on Keynesian theory. These stated that government policies designed to reduce inflation caused higher unemployment, and policies designed to reduce unemployment raised inflation. With stagflation, economists saw that these theories were not always correct.

Causes of stagflation

So, if stagflation goes against some of the most widely accepted principles of macroeconomic theory, what are its causes? One contributing factor is a government overprinting currency, increasing the country’s money supply. Another cause is when the central bank creates credit due to its policies. Both actions lead to inflation, due to the increase in money supply.

If these policies are pursued alongside others that restrict growth, it can cause stagflation. One example would be increasing taxes and interest rates in a bid to slow growth. Due to the conflict between policies designed to slow economic growth and increase inflation at the same time, stagflation takes place.

Another theory is that stagflation is caused by supply shock, or a sudden increase or decrease in supply. For example, if there’s a sudden, unexpected increase in the price of a commodity like oil, prices surge accordingly while profits drop. The conflict between increased prices and reduced profits leads to a stagflation situation.

Examples of stagflation

For a prime example of historic stagflation, we can look at the economic situation in the 1970s. The situation in the United States reflects all of the causes mentioned above, for a perfect storm of stagflation. The country had experienced a period of high economic growth during the 1950s and 1960s, with the Federal Reserve boosting demand and keeping unemployment figures low. However, wages weren’t able to keep up with the rising cost of consumer goods during the 1960s. The oil embargo crisis created supply shock as well, with industries suffering from extremely high oil prices that had a knock-on effect. Demand dropped, prices rose, and stagflation was the result.

Another, more recent example of stagflation occurred in Zimbabwe in 2018 and 2019. A series of economic shocks caused the government to flood the market with money supply to tackle rising national debt and a decline in economic output. The combination of rising inflation and a weak economy led to stagflation.

Could stagflation happen again?

Although the causes of stagflation are only speculative, it’s unlikely that we’ll see a return to the 1970s any time soon. Central banks and governments are careful about pursuing contradictory policies. When productivity increases, it’s important to tighten policy to rein in inflation without letting it get out of control.

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Stagflation is a combination of stagnant economic growth, high unemployment, and high inflation. It's an unnatural situation because inflation is not supposed to occur in a weak economy.

In a normal market economy, slow growth prevents inflation. As a result, consumer demand drops enough to keep prices from rising. Stagflation can only occur if government policies disrupt normal market functioning.

The federal government manipulated its currency to spur economic growth. At the same time, it restricted supply with wage-price controls.

In 2008, the Zimbabwean government printed so much money it went beyond stagflation and turned into hyperinflation.

Stagflation occurs when the government or central banks expand the money supply at the same time they constrain supply. The most common culprit is when the government prints currency. It can also occur when a central bank's monetary policies create credit. Both increase the money supply and create inflation. 

At the same time, other policies slow growth. That happens, for instance, if the government increases taxes. It can also occur when the central bank raises interest rates. Both prevent companies from producing more. When conflicting expansionary and contractionary policies occur, it can slow growth while creating inflation. That's stagflation.

Stagflation got its name during the 1973-1975 recession. There were five quarters when gross domestic product was negative.

Unemployment peaked at 9% in May 1975, two months after the recession ended.

Inflation tripled in 1973, rising from 3.6% in January to 8.7% in December. It rose to a range of between 10% and 12% from February 1974 through April 1975.

How did this happen? Many experts blame the 1973 oil embargo. That's when OPEC cut its oil exports to the United States. Prices quadrupled, triggering inflation in oil.

The 1973 oil embargo alone wasn't enough to cause stagflation. Instead, it was a combination of fiscal and monetary policy that created it.

It started with a mild recession in 1970. GDP was negative for two quarters. Unemployment rose to 6.1%. President Richard Nixon was running for re-election. He wanted to boost growth without triggering inflation. 

On August 15, 1971, he announced three fiscal policies. They got him re-elected. They also sowed the seeds for stagflation. A video of Nixon's speech shows the announcement of significant economic policy changes known as the Nixon Shock.

The Nixon Shock was comprised of three actions that Nixon took.

1. He instituted a 90-day freeze on all wages and prices. He set up a Pay Board and Price Commission to approve any increases after the 90 days. Conveniently, it would control prices until after the 1972 presidential campaign. That's how he planned to control inflation.
2. Nixon imposed a 10% tariff on imports. His goal was to lower the trade deficit and protect domestic industries. Instead, the tariffs raised import prices.
3. He removed the United States from the gold standard. That had kept the dollar's value tied to a fixed amount of gold since the 1944 Bretton Woods Agreement.

Under Bretton Woods, most countries agreed to peg the value of their currencies to either the price of gold or the U.S. dollar. That had turned the dollar into a global currency. 

The crisis occurred when the United Kingdom tried to redeem $3 billion for gold. The United States didn't have that much gold in its reserves at Fort Knox. So Nixon stopped redeeming dollars for gold. That sent the price of the precious metal skyrocketing and the value of the dollar plummeting which sent import prices up even more.

These last two policies raised import prices, which slowed growth. Then growth slowed even more because U.S. companies couldn't raise prices to remain profitable. Since they couldn't lower wages either, the only way to reduce costs was to lay off workers. That increased unemployment. Unemployment reduces consumer demand and slows economic growth. In other words, Nixon's three attempts to boost growth and control inflation had the opposite effect. 

Learning the history of the gold standard will help you understand why the dollar then was backed by gold and why it isn't currently.

The Federal Reserve's attempts to fight stagflation only worsened it. Between 1971 and 1978, it raised the fed funds rate to fight inflation, then lowered it to fight the recession. This "stop-go" monetary policy confused businesses. They kept prices high, even when the Fed lowered rates. That sent inflation up to 13.3% by 1979.  

Federal Reserve Chair Paul Volcker ended stagflation by raising the rate to 20% in 1980. But it was at a high cost. It created the 1980-1982 recession.

In 2011, people became concerned about stagflation again. They worried that the Fed's expansive monetary policies, used to rescue the economy from the 2008 financial crisis, would cause inflation.

At the same time, Congress approved an expansive fiscal policy. It included the economic stimulus package and record levels of deficit spending. Meanwhile, the economy was only growing 1% to 2%. People warned of the risk of stagflation if inflation worsened and the economy didn't improve.

This massive increase in global liquidity prevented deflation, a far greater risk. The Fed won't allow inflation to go beyond its inflation target of 2% for the core inflation rate. If inflation rose above that target, the Fed would reverse course and institute constrictive monetary policy.

The unusual conditions that created stagflation during the 1970s are unlikely to reoccur.

First, the Fed no longer practices stop-go monetary policies. Instead, it commits to a consistent direction. Second, the removal of the dollar from the gold standard was a once-in-a-lifetime event. Third, the wage-price controls that constrained supply wouldn't even be considered today. 

• Stagflation is stagnant economic growth plus high inflation and high unemployment.
• It is caused by conflicting contractionary and expansionary fiscal policies.
• Stagflation got its name during the 1973-1975 recession, when GDP growth was negative for five quarters.
• Because of changes in policy and economic conditions, stagflation is unlikely to reoccur today.