How Does Stagflation Occur?

How Does Stagflation Occur

One of the more common terms in the markets today is stagflation. Most people are unaware of it and ask how does stagflation occur?

The short answer is that in economic terms, stagflation is when demand for goods and services continues to rise but growth is slowing. This is caused by a combination of factors, including increased unemployment and cost-push inflation. If you’re wondering why your economy is slowing, read on to discover the most common causes and how stagflation can be avoided. Inflation is a natural consequence of economic growth, but it can also occur because of various other factors, including a negative supply shock.

Cost-push inflation

A stagflationary spiral occurs when monetary growth slows, and prices rise, resulting in higher unemployment and a weaker economy. Unemployment and inflation are usually inversely related: when unemployment falls, inflation decreases, and vice versa. However, this relationship is unstable, as the 1970s’ stagflation demonstrated. Stagflation can be a dangerous combination, resulting in a perfect storm of economic malaise. Several factors are implicated in the rise and fall of stagflation, including supply shocks and fiscal and monetary policies.

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The first cause of cost-push inflation is an increase in money wages or the price of raw materials. While money wages are rising, the quantity of money in circulation must also increase. This creates a vicious cycle of price rises and falling real GDP. This is also known as built-in inflation, which occurs when businesses price in inflation through higher wages. The central bank’s response is to increase the money supply persistently. The process keeps repeating itself, resulting in the inflationary gap.

Negative supply shock

Stagflation is the result of a shortage of a particular resource, such as oil. It is a more complicated problem than the simple supply-demand relationship, as negative supply shocks often occur in a single country. For example, an oil embargo in 1974-75 in the United States significantly increased the price of oil, which is used to manufacture most goods. This resulted in an enormous supply shock, which negatively impacted the economy, including real GDP, unemployment, and price levels.

Historically, stagflation has been caused by a number of factors, including economic policies and regulations of labor and goods. One such example is the use of harsh monetary policy, such as restricting free markets and raising interest rates. President Richard Nixon imposed a 10% tariff on imports during the 1970s recession, instituted a 90-day price freeze, and removed the U.S. from the gold standard. Most countries peg their currencies to either the U.S. dollar or gold.

Economic growth slowing

The current bout of stagflation has many causes, but one of the major culprits is negative aggregate supply shocks. These shocks slash production and raise costs. A recent pandemic of Covid-19 has triggered lockdowns in many sectors, disrupting global supply chains and reducing labor supply. Rising energy prices, and the Russian invasion of Ukraine, have increased energy prices, and the slowdown is pushing up food and commodity costs.

The underlying cause of stagflation is a sudden spike in oil prices. This spike in oil prices has a multiplier effect, with other parts of the economy being affected as a result. Food prices can rise if chicken populations are depleted by the disease. Other examples include supermarkets passing on higher shipping costs and taxi services adding gasoline surcharges. Although high inflation alone doesn’t cause stagflation, these price increases can inspire consumers to reduce their purchases.

Joblessness

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Economists viewed stagflation and joblessness as virtually impossible up until 50 years ago. They tended to follow the Phillips Curve theory, which holds that inflation and unemployment move in opposite directions. Inflation should rise as unemployment falls. During a stagflationary period, however, the Phillips curve flattens. This is one reason why stagflation is so dangerous.

Stagflation is a combination of high inflation and stagnant or even negative economic growth. Economists usually look at three main macroeconomic variables: inflation, unemployment, and gross domestic product. A rise in GDP may counterbalance a decline in unemployment. However, a drop in real GDP can lead to higher unemployment. Therefore, the United States is at risk of stagflation. You can easily see how stagflation can have catastrophic consequences if you think about it.

Monetary policy

Stagflation occurs when the economy experiences a negative supply shock, where a critical resource is in short supply or becomes more expensive. Crude oil is a prime example of this. When monetary policy fails to address the supply shock, the economy suffers stagflation. In addition, it may be hard for a country to recover from stagflation since unemployment is high.

Monetary policy can either cause stagflation, which is an inflationary cycle, or it can be a response to inflationary pressures. If the Fed is pursuing a monetary policy that aims to increase output while also reducing unemployment, stagflation is likely to result. It is difficult, however, to cure stagflation when it is triggered by the presence of high unemployment and low-interest rates.

Options

Stagflation is one of the worst nightmares of retirees today. While inflation has reached historic highs, the economy is in a state of stagflation. While the federal reserve is hawkish, the supply chain remains broken, and geopolitical events can act as wild cards. There are several options for dealing with stagflation, including a supply-side economics strategy.

Inflation is a big concern for policymakers and market participants alike, but if a country can avoid stagflation, it can use easy policy to boost economic growth. The easy policy can include keeping interest rates low, buying financial assets, and monetizing fiscal deficits. The Fed can even accept some currency weakness to spur growth. A lower currency is good news for borrowers. The external debt level is already higher than 40% of GDP, and stagflation is particularly pernicious when combined.

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