What is stagflation? Economic theories and the significance of the economic condition that frightens all central banks in the world.
Stagflation: what is it? This is what this economic term means, a union between stagnation and inflation, but why is it called the central bank nightmare?
Stagflation occurs when an economy simultaneously exhibits stagnant economic growth, high unemployment and high inflation. It is a very unusual situation, but new shadows of this kind are spreading in this semester of 2022.
A stagnant economy usually reduces demand enough to prevent prices (and therefore inflation) from rising. The more workers are laid off, the less they buy. Slow growth in a normal market economy prevents inflation from rising.
However, if external factors, such as those that are operating this year, push prices up while other conditions weaken the recovery, the stagflation picture can be redrawn.
What is stagflation? Meaning
Stagflation is a condition in which economic growth is slow, unemployment is high and at the same time inflation rises. Stagflation is an economic problem defined equally by its rarity and the lack of consensus among academics on how it occurs and how to get rid of.
Usually, when unemployment is high, spending decreases as do the prices of goods. Stagflation occurs when commodity prices rise while unemployment rises and spending decreases.
Stagflation can be a particularly difficult problem for central banks because most policies aimed at reducing inflation tend to disadvantage the unemployed while policies designed to decrease unemployment increase inflation.
This happened in the United States during the 1970s, when the price of oil was soaring dramatically, increasing the costs of goods and contributing to a rise in unemployment. Consequently, stagnation has increased the inflationary effects on the economy. Since the crisis of the 1970s, there has been no agreement among experts on what exactly caused this economic problem. Each business school offers its own opinion on what went wrong and why.
The issue has made a comeback since the beginning of 2022, when the recovery from the Covid pandemic around the world was abruptly halted by the outbreak of the war in Ukraine. The conflict has accelerated the increase of prices, which were already on the rise especially in the energy sector and compromised all indications on economic growth. Europe appeared particularly vulnerable, with strong dependence on Russian gas and GDP projections in sharp decline. Even in the US, where prices have risen, a recession scenario is assumed.
Central banks, committed to dampening really hot inflation, are meanwhile raising rates, albeit fearing that this could slow the recovery. Will it be stagflation? Experts ask.
What causes stagflation: economic theories
There are two main theories as to what causes stagflation. One theory states that this economic phenomenon is caused in the event that a sudden increase in the cost of oil reduces the productive capacity of an economy. As transportation costs rise, product production and delivery to store shelves become more expensive, and prices rise even when people are laid off.
Another theory is that the confluence of stagnation and inflation are the results of poorly done monetary policies. Simply allowing inflation to rise freely and then suddenly pull the reins is an example of bad monetary policy that some argue contributes to stagflation, while others cite harsh regulation of markets, products and labor accompanied by excessive banking by banks. as another possible cause of stagflation.
Jane Jacobs pointed out that the inability of major schools of economic thought to come to a conclusion on why stagflation occurs stems primarily from scholars’ focus on the nation as the main economic engine relative to cities.
It was his belief that, in order to avoid the stagflation phenomenon, a country needed to provide an incentive for the development of cities that had a balance between production and import.
This idea of essentially diversifying city economies has been criticized for its lack of foundation by some, while others have welcomed it.
Contemporary economists such as Oliver Blanchard cite both the supply shock on asset prices and layoffs, as well as the incorrect Keynesian school predictions as the cause of stagflation and the inability for many to understand it.
The difference between stagflation and inflation
Inflation is a term used by economists to define large price increases. Inflation is the rate at which the prices of goods and services rise within an economy. Inflation can also be defined as the speed with which purchasing power decreases. For example, if inflation is 5% and you spend 100 euros a week on food, the following year you will have to spend 105 euros on the same amount of food.
Economic policy makers, such as the European Central Bank, keep a constant watch on inflation. Central banks do not want the psychology of inflation to enter the minds of consumers. In other words, politicians don’t want consumers to know that prices will always go up. Such a belief would lead the average consumer to close an ever higher wage to the employer to cover the rising cost of living, putting employers and, consequently, the general economy in difficulty.
Stagflation, on the other hand, is a term used by economists to define an economy that has high inflation, a slow or stagnant economic growth rate and a relatively high unemployment rate. Central banks and governments around the world try to avoid stagflation at all costs. With stagflation, a country’s citizens are hit by high inflation rates and high unemployment. The high unemployment rate further contributes to the slowdown of a country’s economy, framing the growth rate of the economy in a range of about one percentage point above or below the zero growth threshold.
Stagflation was experienced globally by many countries during the 1970s, when the price of oil around the world went up sharply.
