Published: 28th 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.
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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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