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The risk of Stagflation in the economy

  • Category
    Economy
  • Published
    30th Mar, 2022

Context

With rising tensions between Russia and Ukraine, disrupting supply chain, and increasing inflation, there are increasingly warning about stagflation in India.

Analysis

What is Stagflation?

  • Stagflation can be understood as a combination of the words
    • Stagnation
    • Inflation
  • Stagflation is a perfect storm of economic ills:
    • slow economic growth
    • high unemployment (economic stagnation)
    • high prices (inflation)
  • Initially, many economists believed stagflation wasn't possible. After all, unemployment and inflation rates generally move in opposite directions.
  • However, as the "Great Inflation" period of the 1970s ultimately proved, stagflation is real, and it can have a devastating effect on the economy.

Worst of both worlds

The term appeared as early as 1965, when British Conservative Party politician Iain Macleod in a speech to the House of Commons said: "We now have the worst of both worlds — not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of 'stagflation' situation and history in modern terms is indeed being made."

How can stagflation be compared to inflation?

Stagflation and inflation are related, but they shouldn't be confused.

Inflation

  • The term inflation refers to a sustained increase in the average price level of all goods and services, not just a few of them, in an economy over time.
  • Reasons: Inflation happens when the money supply grows at a faster rate than the economy can produce goods and services.

Stagflation

  • Stagflation happens when inflation exists in tandem with slow economic growth and high unemployment.
  • Typically, these economic conditions don't occur together. Unemployment and inflation tend to be inversely correlated.
  • So, as unemployment rates increase, inflation usually decreases and vice versa.
  • Of course, as the stagflation of the 1970s illustrated, this relationship isn't always stable or predictable.

What are the factors responsible for Stagflation?

  • The two root causes of stagflation economists generally agree upon are
    • supply shocks
    • fiscal and monetary policies

Supply Shock

  • A supply shock is anything that reduces the economy's capacity to produce goods and services at given prices. For example, throughout the pandemic, there have been supply shocks in:
    • Labor, with fewer people working
    • Goods, for example, semiconductor shortages, which started even before the pandemic
    • Services, as people postponed elective surgeries and other health-care procedures

Poor fiscal and monetary decisions

  • Poor fiscal and monetary decisions also prompt stagflation.

What are the consequences of stagflation?

The trifecta of slow growth, high unemployment, and fast inflation can result into the following:

  • Significant pressure on the economy
  • Distort investment decisions
  • Damaging to-fixed income markets (rising interest rates push bond prices lower and depress equity valuations)
  • As consumer spending slows, corporate revenue declines, exacerbating the overall effect on the economy.
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