Stagflation is most commonly referred to as the simultaneous experience of three separate negative economic phenomena: rising inflation, rising unemployment and a declining demand for goods and services. Despite several examples of stagflating Western economies during the 19th and 20th centuries, many economists did not believe that stagflation could exist because of the Phillips curve, which viewed inflation and recession as diametrically opposite forces.
The term "stagflation" was made popular in 1965 by a member of the British Parliament, Iain Macleod, who told the House of Commons that the U.K. economy had "the worst of both worlds," meaning stagnation and inflation. He referred to it as "a sort of 'stagflation' situation." However, stagflation wouldn't gain worldwide renown until the mid- to late 1970s, when more than half a dozen major economies went through a period of rising prices and unemployment.
Inflation, Unemployment and Recession
Inflation refers to an increase in the supply of money (money stock) that causes the general level of prices in the economy to go up. When more units of money are available to chase the same number of goods, the laws of supply and demand dictate that each individual money unit becomes less valuable.
Not every rise in prices is considered inflation. Prices can rise because consumers demand more goods or because resources become scarcer. Indeed, prices frequently rise and fall for individual commodities. When prices rise as a result of an over-abundance of money stock, it is called inflation.
Unemployment refers to the percentage of the workforce that would like to find a job but is unable to. Economists often differentiate between seasonal or frictional unemployment, which occurs as a natural part of market processes, and structural unemployment (sometimes called institutional unemployment). Structural unemployment is more controversial; some believe that governments must intervene to solve structural unemployment while others believe that government intervention is its root cause.
Recession is commonly defined as two consecutive quarters of negative economic growth as measured by gross domestic product (GDP). It is also known as economic contraction. The National Bureau of Economic Research (NBER) states that recession is "a period of diminishing activity rather than diminished activity." Typically, recessions are characterized by falling demand for existing goods and services, declining real wages, temporary increases in unemployment and an increase in savings.
Explanation of Stagflation
Contemporary monetary or fiscal policy is ill-equipped to handle a period of stagflation. The policy tools prescribed by macroeconomics to combat rising inflation include reduced government spending, increased taxes, rising interest rates and a raising of bank reserve requirements. The remedy for rising unemployment is exactly the opposite: more spending, less taxes, lower interest rates and encouraging banks to lend.
According to Edmund Phelps and Milton Friedman, the Keynesians were wrong to assume that there was a real long-run trade-off between inflation and unemployment. They suggested that loose central bank policies would eventually lead to lower real economic growth and a higher long-run inflation rate.
Other economists contend that demand is limited by production, which serves as a means of securing goods and services. Therefore, any monetary stimulus that dilutes the real wealth created by wealth generators – businesses and entrepreneurs -- and weakens their ability to grow the economy through gains in productivity. The result is a messy recession with dropping output and rising prices.