Context

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

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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.”

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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.

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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.

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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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