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TAGFLATION

Introduction
Stagflation is term that describes a "perfect storm" of economic bad news: high
unemployment, slow economic growth and high inflation. The term was born out
of the prolonged economic slump of the 1970s, when the United States
experienced spiking inflation in the face of a shrinking economy, something
economists had previously thought to be impossible.
The word stagflation is a contraction of "stagnant" and "inflation." When the
economy is stagnant, it means that the gross domestic product (GDP) -- the
standard measure of a nation's total economic output -- is either growing at a very
slow rate or shrinking. The natural result of economic stagnation is increased
unemployment. Businesses lay off employees to save money, which in turn
decreases the purchasing power of consumers, which means less
consumer spending and even slower economic growth.
Economic slowdowns are a normal part of the macroeconomic cycle. When
financial speculation gets out of hand (as it did with the technology stocks of the
late 1990s and the housing market of the mid-2000s), the market needs to stabilize
itself. This usually happens through a temporary, if painful, recession.
But here's the difference between a recession and stagflation: The prolonged period
of slow economic growth is coupled with high rates of inflation. Inflation is the
ongoing increase in prices for goods and services, but it can also be described as an
ongoing decrease in the buying power of money. In a normal year, inflation might
rise two or three percentage points. If the rate of inflation begins to rise past 5 or
even 10 percent, things can get hairy.
The term stagflation was first coined during a period of inflation and
unemployment in the United Kingdom. The United Kingdom experienced an
outbreak of inflation in the 1960s and 1970s.

Central Research
Questions
1.0 What is stagflation?
2.0 What happened during 1970?
3.0 Why is Stagflation so dangerous?
4.0What are the causes of Stagflation?
4.1Keynesian View
4.2Supply Side View
4.3Monetarist View
4.4Other possible causes
5.0What are the effects of Stagflation?
6.0How is Stagflation corrected?
7.0How should we respond to
Stagflation?
8.0How to overcome the situation?

Objective of the study


Specific Objectives
To identify factors that contribute to stagflation.
To analyze the views.
To find out any feasible solution to this problem.
Helps one to understand the concept of inflation for the policy makers to set
out the open market operations.
Helps one to understand the impact of unemployment.
To translate the outcomes on the basis of globalization.
To translate the outcomes on the basis of behavioral economy.

Broad Objectives

To analyze the first incident of Stagflation.


To explore the effects of this in the economy.
Ways to prevent it.
How it affects the south Asian countries.

Literature Review
Phillips (1958) puts the light upon the theory of a kind of tradeoff between the rate of
unemployment and the rate of inflation. Phillips (1958) identified an inverse relationship
between money wage changes and unemployment in the British economy over the years.
This relationship depicts that the inflation rate depends inversely upon the level of
unemployment in an economy. Similar patterns were found in the other countries and
Phillips work was further taken by Solow and Samuelson (1960) made the denotative
association between inflation and unemployment, as when inflation was high,
unemployment was low and vice-versa. Fisher (1920) noted this kind of Phillips curve
relationship way back before the Phillips (1958) where, Phillips' novel curve explained the
behavior of money wages. Since the core task of policy-makers of the state is to avoid both
high unemployment and runaway inflation, Phillips Curve leaves the choice with the state
to choose any one higher and enjoy the lower of other. If we are willing to tolerate high
levels of unemployment, simultaneously we can enjoy the low rates of price inflation and
vice versa. Many macroeconomic text books, such as Hall and Taylors Macroeconomics
(1993, pp. 597-8) and Dornbusch and Fischer (2002 p.472), use the term expectationsaugmented Phillips curve to refer to an aggregate relationship between inflation, expected
inflation, and the unemployment rate.
Friedman (1970) argued that the Phillips curve relationship was only on a short-run
occurrence, as high levels of both inflation and unemployment was experienced by many
countries during the years and hence numerous antagonistic arguments were lifted from a
group of economists headed by Friedman (1970). They argued that trade-off between
inflation and employment is not found present in the longer-run. The significance of this
implication is that central banks should not position the employment goals above the
normal rate.
Brayton, Roberts, and Williams (1999) studied the dependency of price inflation on the
unemployment rate, past price inflation, and standard measures of price supply shocks, to
identify the factors behind simultaneous occurrence of low falling price inflation and low
unemployment in US. Another study regarding Why there is a long run tradeoff between
inflation and unemployment was conducted by Snower and Karanassou (2002), the
authors investigated to identify the impact of price- wage decisions of the different time
orientations (i.e.: past wages and prices and future wages and prices) on the shape of the

long run Phillips Curve. Snower and Karanassou (2002) concluded that an increase in the
money growth raises inflation rate and reduces the unemployment rate in the long run.

Stagflation
Stagflation is a term referring to transitional periods when the economy is simultaneously
experiencing the twin evils of Inflation and high Unemployment, a condition many
economists as late as the 1950s considered a typical of the U.S. economy. Stagflation
occurs when the economy is moving from an inflationary period (increasing prices, but
low unemployment) to a recessionary one (decreasing or stagnant prices and increasing
unemployment). It is caused by an overheated economy. In periods of moderate inflation,
the usual reaction of business is to increase production to capture the benefits of the higher
prices. But if the economy becomes overheated so that price increases are unusually large
and are the result of increases in wages and/or the costs of machinery, credit, or natural
resources, the reaction of business firms is to produce less and charge higher prices.
The term stagflation was first coined 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 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."
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 nonmonetary 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.

Stagflation of
1970
Prior to the 1970s, economists thought it was impossible to have both a stagnant
economy and high inflation. According to the economic principles of John Maynard
Keynes, an influential British economist, inflation was a byproduct of economic
growth. For Keynesians, it's all about supply and demand. When demand is high -as it is during a booming economy -- then prices go up.
What the Keynesians didn't realize was that there were other powerful economic
forces that could throw inflation into an upward spiral. To really understand how
stagflation works, you have to take a trip back to the 1970s.
The word stagflation didn't even exist until the 1970s. From 1958 to 1973, the
United States experienced what's known as the "Post-War Boom." Gross annual
products in Western nations grew by an average of 5 percent annually, fueling a
slow but steady rise in prices (inflation) over the same period.
There were six quarters of shrinking Gross Domestic Product (GDP) growth, while
inflation tripled in 1973, rising from 3.4% to 9.6%. It remained between 10-12%
from February 1974 through April 1975. Unemployment was at 6.1%, a result of
the economy contracting for three quarters.
Why did things go sour in the 1970s? Many experts blame the 1973 oil supply
shocks, when OPEC cut its quota and prices quadrupled. This did trigger some oil
price inflation. However, it took fiscal and monetary policy combined to create this
extreme stagflation.

It turns out that the Federal Reserve's monetary policy during the boom years of the
late '50s and '60s was unsustainable. The economists at the Fed were diehard
Keynesians who believed in something called the Phillips Curve. The Phillips
Curve charts the relationship between unemployment and inflation. Historically,
when unemployment is low, inflation increases, and when unemployment is high,
inflation decreases.
It all started with a mild recession in 1970. In the 1960s, the Fed believed that the
inverse relationship between unemployment and inflation was stable. The Fed
decided to use its monetary policy to increase overall demand for goods and
services and keep unemployment low. The only tradeoff, economists believed,
would be a safely rising rate of inflation
Unfortunately, they got it wrong. The result of unnaturally low unemployment in
the 1960s was something called a wage-price spiral. The government poured
money into the economy to increase demand, making prices rose. Workers, noting
the rise in prices (inflation), expected their wages to rise accordingly. For a while,
employers were willing to raise wages, but then inflation began to rise faster than
wages. Workers weren't willing to supply labor for lower wages, so unemployment
increased even as inflation continued to rise.
But the wage-price spiral alone wasn't enough to trigger killer stagflation. The real
kicker was the OPEC oil embargo of 1973, which brought oil prices to record new
levels. Prices skyrocketed, not only at the gas pump -- where long lines and
shortages were common -- but across all U.S. industries.
In 1970, inflation was 5.5 percent. By 1974, it was 12.2 percent, and then it peaked
at a crippling 13.3 percent in 1979. The stock market ground to a halt. From 1970 to
1979, the S&P 500 returned an average of 5.9 percent annually. But when you
subtract for inflation (average 7.4 percent annually), the market lost value every
year. The annual return on bonds was 2.6 percentage points lower than inflation.

President Richard Nixon was running for re-election, and looked for a way to boost
growth without triggering inflation. On August 13 1971, Nixon and his aides
formulated four economic policies that would succeed in getting Nixon re-elected.
Without realizing it, they also sowed the seeds for stagflation.
First, Nixon instituted wage and price controls, freezing businesses' ability to raise
prices in the U.S. When import prices rose, U.S. businesses couldn't raise prices to
remain profitable. Instead, they had to reduce costs. Since they couldn't lower
wages, they had to lay off workers. This raised unemployment, reducing demand,
and slowing economic growth.
Why did import costs rise? This was a result of Nixon's second action -- removing
the U.S. from the gold standard, which had kept the dollar's value tied to a fixed
amount of gold. Nixon did this to prevent a run on the gold reserves at Fort Knox.
Under the Bretton Woods Agreement, most countries pegged the value of their
currencies to either the price of gold or the dollar. This turned the dollar into a global
currency. As a result, demand for the dollar rose. The crisis was precipitated when
Great Britain tried to redeem $3 billion for gold.
When Nixon took the U.S. off of the gold standard, the price of gold skyrocketed -from $35 an ounce to $120 an ounce. At the same time, the value of the dollar
plummeted. The result? Import prices rose.
To fight inflation, the Fed kept raising the Fed funds rate, reaching a peak of 20% in
1979. However, instead of signaling the market and being consistent, the Fed did so
in a "stop-go" fashion. This confused businesses, many of whom kept prices high.

Why stagflation is so
dangerous?
Economic slowdowns are a normal part of the macroeconomic cycle. When financial
speculation gets out of hand (as it did with the technology stocks of the late 1990s and the
housing market of the mid-2000s), the market needs to stabilize itself. This usually happens
through a temporary, if painful, recession.
But here's the difference between a recession and stagflation: The prolonged period of slow
economic growth is coupled with high rates of inflation. Inflation is the ongoing increase
in prices for goods and services, but it can also be described as an ongoing decrease in the
buying power of money. In a normal year, inflation might rise two or three percentage
points. If the rate of inflation begins to rise past 5 or even 10 percent, things can get hairy.
This is why stagflation is so dangerous. Imagine a scenario in which you have both a
sinking economy and runaway inflation. With high unemployment, consumers have less
money to spend. Add inflation, and the money they do have is worth less and less every
day. If you're on a fixed income, inflation erodes the value of your monthly check. And if
you've managed to save some money, inflation eats away at its value, too. Inflation is a real
confidence killer in an already depressing economic environment.

Causes
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. 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, 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 simulative monetary policy to counteract the resulting recession,
causing a runaway price/wage spiral.

Different economists sought to explain the


phenomenon of stagflation differently. Three
leading views are given below:

Keynesian View:
Keynesian economists blame supply shocks for causing stagflation. They cite
surging energy costs or surging food costs, for example, as the cause of economic
woes. Monetarists cite overly rapid growth in the money supply for causing too

many dollars to chase too few goods. Supply-siders blame high taxes, excessive
regulation of businesses and a persistent welfare state that enables people to live
well without working.The Keynesians explain the phenomenon of stagflation in
terms of upward shift in Phillips curve. This upward shift in the Phillips curve is
caused mainly by various cost-push factors, such as
Increase in the world prices of crude oil;
Wage increases due to strong trade unions;
Wage increases due to higher cost of living during inflationary period;
Changes in the composition of demand for labour in the dynamic
conditions, causing an upward shift in wages; etc.

Supply-side View:
Supply-side economists hold the view that various government actions and
regulations, which raise cost of production and restrict aggregate supply of
goods and services, are responsible for the phenomenon of stagflation.
Higher tax rates, minimum wage legislation, social security measures are
some such actions. A higher marginal tax rate for example, induces workers
to work less.
The underlying assumption it that the individuals while acting as workers,
savers and investors always respond to the changes on the margin.
When the marginal tax rate is raised, it reduces the after-tax pay of the
workers, after-tax interest earnings of the savers, and after-tax return of
the investors.
All this will reduce work effort, saving and investment, which, in turn,
reduce output and employment, and increase prices.

Monetarist View:
According to the monetarists, the phenomenon of stagflation is the result of
changes in inflationary expectations. The monetarist view has been explained in
the Friedman-Phelps model.

The Friedman-Phelps model states that an expansionary monetary policy can


increase employment at the cost of inflation only if the workers do not
correctly anticipate the inflation rate. Such a policy to reduce employment is
doomed to be a failure.
It will appear successful only in the short period as long as the government
is able to fool labour by maintaining an actual inflation rate greater than that
expected by labour.
In the long run, when the labour will correctly anticipate the higher rate of
inflation, the unemployment rate will return to its natural level.
Thus, in the long period, the expansionary monetary policy will lead to an
increase in both the price level and the unemployment rate.
The phenomenon of stagflation is of comparatively recent origin. It depicts a
situation in which prices are sticky and refuse to fall even in the face of poor
demand. In other words, it is a combination of stagnation in demand and persistent
high prices. Stagflation arises when there are rigidities in the economic system and
production costs, supply flows, demand, and prices do not adjust to each other, and
in which, therefore, prices refuse to come down.

Let us look at some other possible causes for


this phenomenon:
The presence of indirect taxation is an important cause for persistent high
cost-price structure of an economy. This is more so when :
The taxed goods have low elasticity of demand,
Taxation is not confined to final consumption goods but is levied on
intermediate goods and other inputs, and
Taxation is not of pure value-added tax variety, but is a multi-point
cumulative variety in which taxes have to be paid even on taxes paid
earlier.
Wages and prices of essential inputs maybe high and protected by law, so
that it is not possible to lower cost of production. The problem becomes

further intractable if employment of labor is protected together with the


emoluments and if there are restrictions relating to the type of technology to
be used.
Policies pursued by the government may be such that productivity and
production are not encouraged. This may be done through various
restrictions like licenses and permits, etc. Dependence upon official sources
of supply involving delays and high costs will also contribute to this
outcome
A country may be critically dependent upon some essential but costly
imports like petroleum products.
The producers may be able to adopt oligopolistic and other collusive
practices.
Stagflation also persists if government policy allows the producers to enjoy
"sheltered market" (that is, they can sell in the domestic market without
facing foreign competition). In that case, the sellers do not have an incentive
to reduce costs and prices.
There can also be some technical and institutional rigidities which prevent a
reduction in costs-and prices even when demand is not strong.
Still others theorists argue that stagflation is simply a natural part of the
business cycle in modern economies or that politics or social structures are
to blame. The failure to forecast, avoid, and contain stagflation as it appears
and disappears in various parts of the global economy suggest that the true
answer may not yet be known.

The second explanation offered by economists as to why stagflation occurs is


simply bad economic policy. For example, allowing too fast of a growth in the
money supply or over regulation of markets. Each of these factors lead to a
dramatic rise in costs and prices and lead to a loss of jobs.

Effects of
Stagflation
Some effects of stagflation are unemployment, rising prices in all goods, all with a
very slow recovery process. Stagflation may also lead to volatility and lack of
confidence in markets, leading to even more reactionary maneuvers by central
banks, such as changing interest and exchange rates.

How is Stagflation
Corrected?
According to Keynesian theory, inflation and economic stagnation cannot
happen simultaneously. Using monetary policy to control one factor, say
inflation, can lead to further economic woes.
Countries around the world have tried different methods to tackle
stagflation. Based on such experiences, it is seen that there is usually a
time lag before an economy turns around. The intervening period is
marked with increased business bankruptcies and hardship to the public
at large.
Policymakers use a combination of fiscal and monetary policies to
control stagflation. While increased spending by the government or
reduced taxes stimulate growth, monetary policies are used to manage
liquidity in the system and to control inflation. Governments also aim to

stabilize key institutions so as to retain public confidence in their


operations.
Measures to reduce costs, such as more efficient design of processes and
machinery as well as alternative technologies and conservation of
resources can also contribute favorably to reverse stagflation.

How Do We Respond to
Stagflation?
Stagflation leads to a drop in consumer confidence and uncertainty about
how long this condition would last. Our best response as consumers is to
make wiser decisions about budgeting and investing.
Financial experts advice us to maintain an emergency fund of 3-6 months
of living expenses at all times. This advice is even more relevant in a
slow economy. Even if funds are available, consider carefully before
purchasing high value items or a second home. Stagflation increases the
risk of job loss. So use every opportunity to sharpen job skills. Ensure
that credit card or other high-interest bearing debt is under control.
Paying down credit cards and maintaining about two cards is a wise
move.

In summary, stagflation is caused by macroeconomic events that are not within our
control. The interim period before the situation is corrected can call for sacrifices
on the part of consumers. Careful planning in both spending and investing can help
us see through such downturns.

How to overcome the


situation
Economy of Pakistan is in serious situation. It also reflects the ignorance with
people concerned with economic planning, financial management and monetary
system. Fiscal and monetary systems are two key components in formulating a
precise, required economic policy and management relates to take suitable steps in
time and this is carried by proper monitoring in place.
It is difficult to deal with stagflation when it occurs. However, if the Government is
sincere it should cut-down its non-developmental budget and decrease reliance on
money borrowing then we can have a chance to cope with the prevailing situation
we have a tendency of over-simplifying economic phenomena and that our
economy has evolved into a force which can survive even a deeper turmoil.

Findings
In the end an economy suffering from stagflation has a hard time recovering.
Normally to curb inflation, the Federal Reserve raises interest rates, however this
affects unemployment. And to combat high unemployment, interest rates are
generally cut, but this leads to inflation. Basically, the government has little power
to achieve the right balance to combat both economic crises at the same.

Recommendations
Stagflation leads to a drop in consumer confidence and uncertainty about how long
this condition would last. Our best response as consumers is to make wiser
decisions about budgeting and investing .
Financial experts advice us to maintain an emergency fund of 3-6 months of living
expenses at all times. This advice is even more relevant in a slow economy. Even if
funds are available, consider carefully before purchasing high value items or a
second home. Stagflation increases the risk of job loss. So use every opportunity to
sharpen job skills. Ensure that credit card or other high-interest bearing debt is
under control. Paying down credit cards and maintaining about two cards is a wise
move.

Conclusion
The flip side of a world awash with liquidity is a world facing depressed aggregate
demand. There is one positive note in this dismal picture; the sources of global growth
today are more diverse than they were a decade ago. The real engines of global growth in
recent years have been developing countries. Nevertheless, slower growth or possibly a
recession in the worlds largest economy inevitably has global consequences. There will
be a global slowdown. If monetary authorities respond appropriately to growing
inflationary pressure recognizing that much of it is imported, and not a result of excess
domestic demand we may be able to manage our way through it. But if they raise interest
rates relentlessly to meet inflation targets, we should prepare for the worst: another episode
of stagflation. If the central banks go down this path, they will no doubt eventually succeed
in wringing inflation out of the system.

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