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Two main yardsticks of a modern economy’s performance are the rate of growth in the production of goods and services and the inflation rate. When the production of goods and services is growing slowly or is falling (generally accompanied by a rising unemployment rate), stagnation occurs. When the prices of goods and services are rising, inflation occurs. Stagflation, a term attributed to the British politician Iain Macleod, refers to a situation in which an economy experiences stagnation and inflation simultaneously.

As recently as the 1960s, the conventional wisdom in macroeconomics was that inflation and stagnation could not appear at the same time. Economists generally believed that there was a stable, inverse relationship between the rate of inflation (the percentage change in the average level of prices) and the unemployment rate (the percentage of the labor force that is unemployed) as illustrated by the Phillips curve, made famous by the New Zealand economist A. W. H. Phillips (1914-1975). The Phillips curve presented policymakers with a trade-off: They could lower unemployment by stimulating demand but at the cost of higher inflation; or they could lower inflation but at the cost of higher unemployment. Policy discussions in the 1960s centered on which point on the Phillips curve was most desirable.

Consistent with the Phillips curve trade-off, the 1960s saw inflation in the United States increase and unemployment decline, with the unemployment rate falling to 3.5 percent by 1969 while inflation rose to 6.2 percent. In 1970, however, the unemployment rate increased substantially to 4.9 percent with little decrease in inflation. This was the start of a dismal decade for the large industrialized economies. As a whole, the Group of Seven (the seven largest capitalist economies) saw inflation double and real growth halve compared to the 1960s. This experience of relatively high inflation, slow growth, and high unemployment kindled interest in the causes of stagflation.

Explanations For Stagflation

Economists developed two explanations for stagflation in industrialized economies. The first sees stagflation as a phase in an economic cycle that begins with excessive growth in spending, typically fueled by higher-than-nor-mal growth in the money supply. Initially the growth in spending causes prices to rise and, in response, firms to expand production and employment so that the economy experiences higher inflation and lower unemployment. As argued by the American economists Milton Friedman (1912-2006) and Edmund S. Phelps (b. 1933), the decline in unemployment results from the higher inflation being unexpected so that real wages (i.e., wages adjusted for inflation) fall. Lower real wages lead workers to demand higher real wages, commensurate with higher expected inflation, in the second phase of the economic cycle, causing the unemployment rate to rise back toward what Friedman called the natural rate of unemployment, the level of unemployment that occurs when actual and expected inflation are equal.

The first explanation fits the U.S. stagflation of 1970. According to this view, the rising inflation of the 1960s caused expected inflation to increase, shifting the Phillips curve up in 1970, with the result that inflation remained high while the unemployment rate rose. The U.S. wage-price controls of the early 1970s were an attempt to lower expected inflation and shift the Phillips curve downward, in the hope of reducing inflation without having to increase unemployment.

The second explanation for stagflation focuses on autonomous events that make production more expensive and cause firms to raise their prices. This view is more relevant to the general stagflation of the later 1970s, the source of which is thought to have been the large increases in oil prices in 1973 and 1979. Given that energy is an important component of most goods, a large increase in energy prices increases the costs of production for most firms. Firms are willing to supply the same level of output only if their prices rise. The oil price increase is referred to as an aggregate supply shock. It triggers firms to raise prices and lower output. An adverse supply shock such as a large increase in energy prices shifts the Phillips curve upward and again results in both inflation and rising unemployment.

Not all economists believe that the stagflation of the later 1970s can be blamed on oil prices. Robert B. Barsky and Lutz Kilian (2002), for example, believe the first explanation holds for this episode too. They argue that the stagflation occurred largely because policymakers believed the natural rate of unemployment was lower than it actually was, leading them to overstimulate spending in a misguided attempt to push down the unemployment rate. The explanations are not mutually exclusive so that both may have contributed to the stagflation of the 1970s. An adverse supply shock should not cause sustained higher inflation unless accompanied by higher rates of growth in the money supply.

Developing countries, particularly in Latin America, have often suffered bouts of stagflation. An alternative explanation for stagflation in such economies focuses on the macroeconomic effects of exchange rate devaluations, as analyzed for example by Paul Krugman and Lance Taylor (1978). Most developing economies have fixed nominal exchange rates. If there is a balance of payments deficit, international agencies often prescribe a devaluation of the currency in order to reduce trade deficits. Such devaluations, however, may lead to short-run decreases in output along with higher inflation. Given rigidity in nominal wage rates and prices marked up from costs, the devaluation can result in reduced domestic aggregate demand because of the redistribution of income away from labor, which is assumed to have a higher marginal propensity to spend. Domestic demand can also fall from the decline in real money holdings as prices rise in response to higher import costs and from the increase in ad valorem taxes on imports. Thus devaluations can lead to periods of stagflation.

Policy Responses

The appropriate policy response to stagflation depends on its cause. If the stagflation is the result of policy-initiated excessive stimulation of spending so that the unemployment rate falls below the natural rate initially and then rises along with inflationary expectations, policymakers need to admit their error and to convince people that they should not build higher inflation rates into contracts. The problem, of course, is that people will be skeptical, so that the policymakers will need to establish credibility that they are truly adverse to inflation.

The suitable response to stagflation caused by aggregate supply shocks is less clear. One response is to do nothing and let the economy adjust as best it can to the shock. If energy prices will be permanently higher, the economy needs to make the changes to the new environment. The likely outcome is a short burst of inflation and a rise in unemployment followed by a gradual return to lower unemployment and stable prices. If energy price increases are temporary, policymakers may choose either to reduce the unemployment effects (by stimulating spending and increasing inflation) or to reduce the inflation effects (by restricting spending and increasing unemployment). The latter choice was the one taken by the administration of Gerald R. Ford after the 1973 oil price shock when it tightened monetary and fiscal policy in 1974 and exhorted households to cut spending as part of President Ford’s famous “Whip Inflation Now” (WIN) campaign. The result was a large increase in unemployment with a peak unemployment rate of 8.5 percent in 1975.

Beginning in the early 1990s, inflation targeting by central banks has been advocated as a solution to the first cause of stagflation. If adopted, however, this policy will make the unemployment effects of supply shocks more severe because the response of policymakers will be to reduce spending growth in order to slow the inflation rate. A flexible inflation target that allows for short-run bursts of inflation from supply shocks is one possible remedy.

Bibliography:

Barsky, Robert B., and Lutz Kilian. 2002. Do We Really Know That Oil Caused the Great Stagflation? A Monetary
In NBER Macroeconomics Annual 2001, eds. Ben S. Bernanke and Kenneth Rogoff, 137–182. Cambridge, MA: MIT Press.
Blinder, Alan S. 1979. Economic Policy and the Great Stagflation. New York: Academic Press.
Bruno, Michael, and Jeffrey D. Sachs. 1985. Economics of Worldwide Stagflation. Cambridge, MA: Harvard University Press.
Krugman, Paul, and Lance Taylor. 1978. Contractionary Effects of Devaluation. Journal of International Economics 8 (3): 445–456.