Stagflation- What is it? And why is it so Bad?

Updated November 19,2008

Stagflation

The simple definition of Stagflation is a "stagnant economy coupled with price inflation".

Thus the term Stagflation.

In other words, in stagflation prices are going up while the economy is going down.  The word was coined during the inflationary period of the 1970's.

 Under normal conditions one would expect inflation to heat up the economy.  That is one reason the FED generally increases interest rates during periods of higher inflation. This helps to cool the economy and prevent inflation from spiraling out of control.

Of course ,if you have read other articles on this site, you will know that the primary cause  of inflation is an increase in the money supply.

So clamping down on interest rates is kind of like stomping on the accelerator with one foot (increasing the money supply) and stomping on the brakes with the other (increasing interest rates). 

The net effect is not good for your car. In the same way it doesn't help the economy either.  But we digress (back to stagflation).

Remember, under normal circumstances increasing inflation equals an increasing economy as all that new money begins flowing around.

But in the 1970's we saw something unusual, inflation and a recession at the same time.  This was so unusual that they coined a new term "stagflation" to describe the situation.

Basically, what happened in stagflation was that there was plenty of liquidity in the system and people were spending money as quickly as they got it because prices were going up quickly, (price inflation).

But the rapid price increases in the price of oil caused many businesses to become unprofitable, so they began laying off workers.  This threw the economy into a tailspin as unemployment grew in spite of an increase in the money supply.

The end result was stagflation, i.e. price inflation and high unemployment and a disastrous economy. Finally, the FED cut the money supply, oil prices moderated, and the economy was able to get back on it's feet.

 The major problem with stagflation is that the normal methods of increasing interest rates doesn't help the situation. The only reason it helps  in times of high economic activity is because it slows the "velocity of money" or the speed at which it changes hands.

In contrast, when the economy is weak the standard medicine administered by the FED is to lower interest rates to stimulate the economy.  Unfortunately, it is impossible to stimulate the economy by lowering rates while simultaneously fighting inflation by raising rates.

So there is the catch.  What do you do in Stagflation? Well at this point the Government is forced to face the real problem (which isn't interest rates at all but the money supply).  It has to reduce the money supply and get the economy back on a firm footing.

That is what finally happened in the early 1980's and that is what is happening now, although not by choice as the market collapses and banks fail the money supply and the velocity of money is contracting.

The current situation is a result of years of inflation because low foreign wages and high demand for US paper debt, were able to keep a cap on our inflation.  But finally higher oil prices are igniting the old fires of inflation while the sub-prime mess is unraveling the economy placing us in much the same situation as in the 1970s.

Unfortunately, currently the FED is still in denial about the stagflation situation and is trying to lower interest rates and increase the money supply by using massive bailouts, to fight the stalling economy and it isn't doing very well. 

For more information see:

What is Inflation?

What is Disinflation

What is Deflation?

Inflation Cause and Effects

Deflation Precondition- By Robert Prechter

Has this article been helpful? We appreciate your feedback.

Subscribe to our FREE monthly E-zine 
and we will keep you up-to-date on what is happening in the area of inflation, interest rates and market trends.

Back to the top