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.

How can stagflation be compared to inflation?

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

• Inflation
  • The terminflation 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 whenthe money supply grows at a faster rate than the economy can produce goods and services.
• Stagflation

• • Stagflationhappens 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 decisionsalso 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.