Stagflation, a portmanteau of stagnation and inflation, is a term used in economics to

describe a situation where the inflation rate is high, the economic growth rate slows
down, and unemployment remains steadily high. It raises a dilemma for economic
policy since actions designed to lower inflation may exacerbate unemployment, and
vice versa.
The term is generally attributed to a British politician who became chancellor of the
exchequer in 1970, Iain Macleod, who coined the phrase in his speech to Parliament in
1965.[1][2][3][4] [notes 1]
In the version of Keynesian macroeconomic theory which was dominant between the
end of WWII and the late-1970s, inflation and recession were regarded as mutually
exclusive, the relationship between the two being described by the Phillips curve.
Stagflation is very costly and difficult to eradicate once it starts, in human terms as well
as in budget deficits.
In the political arena, one measure of stagflation, termed the Misery Index (derived by
the simple addition of the inflation rate to the unemployment rate), was used to swing
presidential elections in the United States in 1976 and 1980.

The Great InflationEdit

The term stagflation was first coined [notes 2] during a period of inflation and
unemployment in the United Kingdom. The United Kingdom experienced an outbreak of
inflation in the 1960s and 1970s. As early as 17 November 1965, Iain Macleod, the
spokesman on economic issues for the United Kingdoms Conservative Party, warned of
the gravity of the UK economic situation in the House of Commons: "We now have the
worst of both worldsnot 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."[3][5]
With these words, Macleod coined the term stagflation.(2) In a Bank of England
working papers series article authors, Edward Nelson and Kalin Nikolov, (2002)
examined causes and policy errors related to the Great Inflation in the United Kingdom
in the 1970s, arguing that as inflation rose in the 1960s and 1970s, UK policy makers
failed to recognize that the primary role of monetary policy in controlling inflation and
instead attempted to use non-monetary policies and devices to respond to the
economic crisis. Policy makers also made "inaccurate estimates of the degree of excess
demand in the economy, contributed significantly to the outbreak of inflation in the
United Kingdom in the 1960s and 1970s.[3]

CausesEdit
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. [6][7][8] Milton
Friedman famously described this situation as "too much money chasing too few
goods".
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,[9] and the government can cause stagnation by excessive
regulation of goods markets and labour markets.[10] 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 price/wage spiral.[11]

Postwar Keynesian and monetarist viewsEdit

Early Keynesianism and monetarism
Up to the 1960s many Keynesian economists ignored the possibility of stagflation,
because historical experience suggested that high unemployment was typically
associated with low inflation, and vice versa (this relationship is called the Phillips
curve). The idea was that high demand for goods drives up prices, and also encourages
firms to hire more; and likewise high employment raises demand. However, in the 1970s
and 1980s, when stagflation occurred, it became obvious that the relationship between
inflation and employment levels was not necessarily stable: that is, the Phillips
relationship could shift. Macroeconomists became more skeptical of Keynesian theories,
and the Keynesians themselves reconsidered their ideas in search of an explanation of
stagflation.[12]
The explanation for the shift of the Phillips curve was initially provided by
the monetarist economist Milton Friedman, and also by Edmund Phelps. Both argued
that when workers and firms begin to expect more inflation, the Phillips curve shifts up
(meaning that more inflation occurs at any given level of unemployment). In particular,
they suggested that if inflation lasted for several years, workers and firms would start to
take it into account during wage negotiations, causing workers' wages and firms' costs
to rise more quickly, thus further increasing inflation. While this idea was a severe
criticism of early Keynesian theories, it was gradually accepted by most Keynesians, and
has been incorporated into New Keynesian economic models.

Neo-Keynesianism
Neo-Keynesian theory distinguished two distinct kinds of inflation: demand-pull (caused
by shifts of the aggregate demand curve) and cost-push (caused by shifts of the
aggregate supply curve). Stagflation, in this view, is caused by cost-push inflation. Costpush inflation occurs when some force or condition increases the costs of production.
This could be caused by government policies (such as taxes), or from purely external
factors such as a shortage of natural resources or an act of war.
Contemporary Keynesian analyses argue that stagflation can be understood by
distinguishing factors that affect aggregate demand from those that affect aggregate
supply. While monetary and fiscal policy can be used to stabilise the economy in the
face of aggregate demand fluctuations, they are not very useful in confronting
aggregate supply fluctuations. In particular, an adverse shock to aggregate supply, such
as an increase in oil prices, can give rise to stagflation. [13]

Supply theory
Fundamentals
Supply theories[14] are based on the neo-Keynesian cost-push model and attribute
stagflation to significant disruptions to the supply side of the supply-demand market
equation, for example, when there is a sudden real or relative scarcity of key
commodities, natural resources, or natural capital needed to produce goods and
services. Other factors may also cause supply problems, for example, social and
political conditions such as policy changes, acts of war, extremely restrictive
government control of production (For example monopolising Dictatorships).[citation
needed] In this view, stagflation is thought to occur when there is an adverse supply
shock (for example, a sudden increase in the price of oil or a new tax) that causes a
subsequent jump in the "cost" of goods and services (often at the wholesale level). In
technical terms, this results in contraction or negative shift in an economy's
aggregate supply curve.[citation needed]

In the resource scarcity scenario (Zinam 1982), stagflation results when economic
growth is inhibited by a restricted supply of raw materials. [15][16] That is, when the
actual or relative supply of basic materials (fossil fuels (energy), minerals, agricultural
land in production, timber, etc.) decreases and/or cannot be increased fast enough in
response to rising or continuing demand. The resource shortage may be a real physical
shortage or a relative scarcity due to factors such as taxes or bad monetary policy
which have affected the "cost" or availability of raw materials. This is consistent with
the cost-push inflation factors in neo-Keynesian theory (above). The way this plays out
is that after supply shock occurs, the economy will first try to maintain momentum
that is, consumers and businesses will begin paying higher prices in order to maintain
their level of demand. The central bank may exacerbate this by increasing the money
supply, by lowering interest rates for example, in an effort to combat a recession. The
increased money supply props up the demand for goods and services, though demand
would normally drop during a recession.[citation needed]
In the Keynesian model, higher prices will prompt increases in the supply of goods and
services. However, during a supply shock (i.e. scarcity, "bottleneck" in resources, etc.),
supplies don't respond as they normally would to these price pressures. So, inflation
jumps and output drops, producing stagflation.[citation needed]

Explaining the 1970s stagflation

Further information: Nixon Shock
Following Richard Nixon's imposition of wage and price controls on 15 August 1971, an
initial wave of cost-push shocks in commodities was blamed for causing spiraling prices.
Perhaps the most notorious factor cited at that time was the failure of the Peruvian
anchovy fishery in 1972, a major source of livestock feed.[17] The second major shock
was the 1973 oil crisis, when the Organization of Petroleum Exporting Countries (OPEC)
constrained the worldwide supply of oil.[18] Both events, combined with the
overall energy shortage that characterised the 1970s, resulted in actual or relative
scarcity of raw materials. The price controls resulted in shortages at the point of
purchase, causing, for example, queues of consumers at fuelling stations and increased
production costs for industry.[19]

Theoretical responses

Under this set of theories, the solution to stagflation is to restore the supply of
materials. In the case of a physical scarcity, stagflation is mitigated either by finding a
replacement for the missing resources or by developing ways to increase economic
productivity and energy efficiency so that more output is produced with less input. For
example, in the late 1970s and early 1980s, the scarcity of oil was relieved by increases
in both energy efficiency and global oil production. This factor, along with adjustments
in monetary policies, helped end stagflation.[citation needed]

Recent viewsEdit
Until recently no macroeconomic policy had been able to predict the occurrence of
stagflation.
After the fact, and several years of research, a convincing explanation was provided
based on the effects of adverse supply shocks on both prices and output. [20] According
to Blanchard (2009), these adverse events were one of two components of stagflation;
the other was "ideas", which Robert Lucas (famous for the Lucas Supply Curve), Thomas
Sargent, and Robert Barro were cited as expressing as "wildly incorrect" and
"fundamentally flawed" predictions [of Keynesian economics] which, they said, left
stagflation to be explained by "contemporary students of the business cycle".[20] In this

discussion, Blanchard hypothesizes that the recent oil price increases could trigger
another period of stagflation, although this has not yet happened (pg. 152).

Neoclassical viewsEdit
A purely neoclassical view[21] of the macroeconomy rejects the idea that monetary
policy can have real effects. Neoclassical macroeconomists argue that real economic
quantities, like real output, employment, and unemployment, are determined by real
factors only. Nominal factors like changes in the money supply only affect nominal
variables like inflation. The neoclassical idea that nominal factors cannot have real
effects is often called "monetary neutrality"[22] or also the "classical dichotomy".
Since the neoclassical viewpoint says that real phenomena like unemployment are
essentially unrelated to nominal phenomena like inflation, a neoclassical economist
would offer two separate explanations for 'stagnation' and 'inflation'. Neoclassical
explanations of stagnation (low growth and high unemployment) include inefficient
government regulations or high benefits for the unemployed that give people less
incentive to look for jobs. Another neoclassical explanation of stagnation is given by real
business cycle theory, in which any decrease in labour productivity makes it efficient to
work less. The main neoclassical explanation of inflation is very simple: it happens when
the monetary authorities increase the money supply too much.[23]
In the neoclassical viewpoint, the real factors that determine output and unemployment
affect the aggregate supply curve only. The nominal factors that determine inflation
affect the aggregate demand curve only.[24] When some adverse changes in real factors
are shifting the aggregate supply curve left at the same time that unwise monetary
policies are shifting the aggregate demand curve right, the result is stagflation.
Thus the main explanation for stagflation under a classical view of the economy is
simply policy errors that affect both inflation and the labour market. Ironically, a very
clear argument in favour of the classical explanation of stagflation was provided by
Keynes himself. In 1919, John Maynard Keynes described the inflation and economic
stagnation gripping Europe in his book The Economic Consequences of the Peace.
Keynes wrote:
"Lenin is said to have declared that the best way to destroy the Capitalist System
was to debauch the currency. By a continuing process of inflation, governments
can confiscate, secretly and unobserved, an important part of the wealth of their
citizens. By this method they not only confiscate, but they confiscate arbitrarily;
and, while the process impoverishes many, it actually enriches some." [...]
"Lenin was certainly right. There is no subtler, no surer means of overturning the
existing basis of society than to debauch the currency. The process engages all
the hidden forces of economic law on the side of destruction, and does it in a
manner which not one man in a million is able to diagnose."
Keynes explicitly pointed out the relationship between governments printing money and
inflation.
"The inflationism of the currency systems of Europe has proceeded to
extraordinary lengths. The various belligerent Governments, unable, or too timid
or too short-sighted to secure from loans or taxes the resources they required,
have printed notes for the balance."
Keynes also pointed out how government price controls discourage production.
"The presumption of a spurious value for the currency, by the force of law
expressed in the regulation of prices, contains in itself, however, the seeds of
final economic decay, and soon dries up the sources of ultimate supply. If a man
is compelled to exchange the fruits of his labours for paper which, as experience
soon teaches him, he cannot use to purchase what he requires at a price

comparable to that which he has received for his own products, he will keep his
produce for himself, dispose of it to his friends and neighbours as a favour, or
relax his efforts in producing it. A system of compelling the exchange of
commodities at what is not their real relative value not only relaxes production,
but leads finally to the waste and inefficiency of barter."
Keynes detailed the relationship between German government deficits and inflation.
"In Germany the total expenditure of the Empire, the Federal States, and the
Communes in 191920 is estimated at 25 milliards of marks, of which not above
10 milliards are covered by previously existing taxation. This is without allowing
anything for the payment of the indemnity. In Russia, Poland, Hungary, or Austria
such a thing as a budget cannot be seriously considered to exist at all."
"Thus the menace of inflationism described above is not merely a product of the
war, of which peace begins the cure. It is a continuing phenomenon of which the
end is not yet in sight."

Keynesian in the short run, classical in the long run

While most economists believe that changes in money supply can have some real
effects in the short run, neoclassical and neo-Keynesian economists tend to agree that
there are no long-run effects from changing the money supply. Therefore, even
economists who consider themselves neo-Keynesians usually believe that in the long
run, money is neutral. In other words, while neoclassical and neo-Keynesian models are
often seen as competing points of view, they can also be seen as two descriptions
appropriate for different time horizons. Many mainstream textbooks today treat the neoKeynesian model as a more appropriate description of the economy in the short run,
when prices are 'sticky', and treat the neoclassical model as a more appropriate
description of the economy in the long run, when prices have sufficient time to adjust
fully.[citation needed]
Therefore, while mainstream economists today might often attribute short periods of
stagflation (not more than a few years) to adverse changes in supply, they would not
accept this as an explanation of very prolonged stagflation. More prolonged stagflation
would be explained as the effect of inappropriate government policies: excessive
regulation of product markets and labor markets leading to long-run stagnation, and
excessive growth of the money supply leading to long-run inflation. [citation needed]

Alternative viewsEdit
As differential accumulation
Main article: Differential accumulation
Political economists Jonathan Nitzan and Shimshon Bichler have proposed an
explanation of stagflation as part of a theory they call differential accumulation, which
says firms seek to beat the average profit and capitalisation rather than maximise.
According to this theory, periods of mergers and acquisitions oscillate with periods of
stagflation. When mergers and acquisitions are no longer politically feasible
(governments clamp down with anti-monopoly rules), stagflation is used as an
alternative to have higher relative profit than the competition. With increasing mergers
and acquisitions, the power to implement stagflation increases.
Stagflation appears as a societal crisis, such as during the period of the oil crisis in the
70s and in 2007 to 2010. Inflation in stagflation, however, doesn't affect all firms
equally. Dominant firms are able to increase their own prices at a faster rate than
competitors. While in the aggregate no one appears to be profiting, differentially
dominant firms improve their positions with higher relative profits and higher relative
capitalisation. Stagflation is not due to any actual supply shock, but because of the

societal crisis that hints at a supply crisis. It is mostly a 20th and 21st century
phenomenon that has been mainly used by the "weapondollar-petrodollar coalition"
creating or using Middle East crises for the benefit of pecuniary interests.[25]

Demand-pull stagflation theory

Demand-pull stagflation theory explores the idea that stagflation can result exclusively
from monetary shocks without any concurrent supply shocks or negative shifts in
economic output potential. Demand-pull theory describes a scenario where stagflation
can occur following a period of monetary policy implementations that cause inflation.
This theory was first proposed in 1999 by Eduardo Loyo of Harvard University's John F.
Kennedy School of Government.[26]

Supply-side theory
Supply-side economics emerged as a response to US stagflation in the 1970s. It largely
attributed inflation to the ending of the Bretton Woods system in 1971 and the lack of a
specific price reference in the subsequent monetary policies (Keynesian and
Monetarism). Supply-side economists asserted that the contraction component of
stagflation resulted from an inflation-induced rise in real tax rates (see bracket creep)
[

citation needed]

Austrian School of economics

Adherents to the Austrian School maintain that creation of new money ex nihilo benefits
the creators and early recipients of the new money relative to late recipients. Money
creation is not wealth creation; it merely allows early money recipients to outbid late
recipients for resources, goods, and services. Since the actual producers of wealth are
typically late recipients, increases in the money supply weakens wealth formation and
undermines the rate of economic growth. Says Austrian economist Frank Shostak:
"The increase in the money supply rate of growth coupled with the slowdown in the rate
of growth of goods produced is what the increase in the rate of price inflation is all
about. (Note that a price is the amount of money paid for a unit of a good.) What we
have here is a faster increase in price inflation and a decline in the rate of growth in the
production of goods. But this is exactly what stagflation is all about, i.e., an increase in
price inflation and a fall in real economic growth. Popular opinion is that stagflation is
totally made up. It seems therefore that the phenomenon of stagflation is the normal
outcome of loose monetary policy. This is in agreement with [Phelps and Friedman (PF)].
Contrary to PF, however, we maintain that stagflation is not caused by the fact that in
the short run people are fooled by the central bank. Stagflation is the natural result of
monetary pumping which weakens the pace of economic growth and at the same time
raises the rate of increase of the prices of goods and services."[27]