Stagflation

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“In economics, stagflation is the situation when both the inflation rate and the unemployment rate are high. It is a difficult economic condition for a country, because then inflation and economic stagnation are occurring simultaneously, and until recently no macroeconomic policy had predicted this occurrence.


Economists offer two principal explanations for why stagflation occurs. First, stagflation can result when the productive capacity of an economy is reduced by an unfavorable supply shock, such as an increase in the price of oil for an oil importing country. Such an unfavorable supply shock tends to raise prices at the same time that it slows the economy by making production more costly and less profitable. This type of stagflation presents a policy dilemma because actions that are meant to assist with fighting inflation might worsen economic stagnation and vice versa.


Second, both stagnation and inflation can result from inappropriate macroeconomic policies. For example, central banks can cause inflation by permitting excessive growth of the money supply, and the government can cause stagnation by excessive regulation of goods markets and labor markets, either of these factors can cause stagflation. Excessive growth of the money supply taken to such an extreme that it must be reversed abruptly can clearly be a cause. Both types of explanations are offered in analyses of the global stagflation of the 1970s: it began with a huge rise in oil prices, but then continued as central banks used excessively stimulative monetary policy to counteract the resulting recession, causing a runaway wage-price spiral.”