What is stagflation?

The term stagflation arose from the concepts of "stagnation" and “inflation”. It is used to describe an economic situation with high inflation and stagnation of the economy, with small or negative increases in GDP.

Traditionally, it was considered that recession (negative growth rates and increasing unemployment) and inflation (higher prices) were two problems that were incompatible in an economy; if one occurred, then the other could not occur. Over time, however, it was observed that both problems can occasionally co-exist, one of the most difficult situations to arrest. This is because the solutions put forward to control inflation or reactivate the economy act in opposite directions. To combat inflation, measures are usually taken which drive down consumption, such as higher interest rates, higher taxes etc.; at the same time, this restricts economic growth; whereas, attempts are made to reactivate the economy by lowering interest rates, increasing public expenditure etc., pushing up prices, and therefore inflation too.

The best-known example of stagflation occurred in the 1970s during the oil crisis, when OPEC stopped exporting oil to the West. This brought about an extraordinary hike in the price of oil, creating inflation and recession among oil importers.

Causes of stagflation

The stagflation phenomenon usually occurs in mixed economies in which the principles of a free market economy are combined with regulatory measures taken by governments. The causes of stagflation are related to measures such as the establishment of a minimum wage, unemployment subsidies, government aid, tax and monetary policy decision-making etc., which can make the economy behave in a different manner to that dictated by theory (the law of supply and demand on which a market economy is based), and bring about distortions.

The stagflation phenomenon is one of the most anomalous economic scenarios and is difficult to correct, because the economic measures taken to address a recession are usually to the detriment of inflation, and vice-versa.