Inflation vs. Stagflation: An Overview

Inflation is a term used by economists to define broad increases in prices. Inflation is the rate at which the price of goods and services in an economy increases. Inflation can also be defined as the rate at which purchasing power declines. For example, if inflation is at 5% and you currently spend $100 per week on groceries, the following year you would need to spend $105 for the same amount of food.

Stagflation is a term used by economists to define an economy that has inflation, a slow or stagnant economic growth rate, and a relatively high unemployment rate. Economic policymakers across the globe try to avoid stagflation at all costs. With stagflation, a country's citizens are affected by high rates of inflation and unemployment. High unemployment rates further contribute to the slowdown of a country's economy, causing the economic growth rate to fluctuate no more than a single percentage point above or below zero.

Key Takeaways

  • Inflation is the rate at which the price of goods and services in an economy increases.
  • Stagflation refers to an economy that has inflation, a slow or stagnant economic growth rate, and a relatively high unemployment rate.
  • With stagflation, a country's citizens are affected by high rates of inflation and unemployment.
  • Inflation is natural, expected, and can be managed, while stagflation is avoided at all costs.
  • There are three main catalysts for inflation: demand pull-inflation, cost-pull inflation, and built-in inflation.
  • The reasons for stagflation vary but are mainly due to harsh regulations combined with an increase in the money supply.
  • It is believed that stagflation will most likely never occur again because poor government policies that led to it in the 1970s would not be used.

Inflation

Economic policymakers like the Federal Reserve maintain constant vigilance for signs of inflation. Policymakers do not want inflation psychology to settle into the minds of consumers. In other words, policymakers do not want consumers to assume that prices will always go up. Such beliefs lead to things like employees asking employers for higher wages to cover the increased costs of living, which strains employers and, therefore, the general economy.

The causes of inflation can be classified into three types: demand-pull inflation, cost-push inflation, and built-in inflation.

Demand-pull inflation is when the overall demand for goods and services in an economy increases more rapidly than the economy's production capacity. It creates a demand-supply gap with higher demand and lower supply, which results in higher prices. Additionally, an increase in the money supply in an economy also leads to inflation. With more money available to individuals, positive consumer sentiment leads to higher spending. This increases demand and leads to a price rise.

Money supply can be increased by the monetary authorities either by printing and giving away more money to the individuals, or by devaluing (reducing the value of) the currency. In all such cases of demand increase, the money loses its purchasing power.

Cost-push inflation is a result of an increase in the prices of production process inputs. Examples include an increase in labor costs to manufacture a good or offer a service or an increase in the cost of raw materials. These developments lead to higher costs for the finished product or service and contribute to inflation.

Cost-push inflation occurred after Hurricane Katrina destroyed gas supply lines in the region. The demand for gas did not change but the lack of supply raised the price of gas to $5 a gallon.

Built-in inflation is the third cause that links to adaptive expectations. As the price of goods and services rises, labor expects and demands higher wages to maintain their cost of living. Their increased wages result in higher cost of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.

Stagflation

The term "stagflation" was first used in the United Kingdom by politician Iain Macleod in the 1960s. Stagflation was experienced globally by many countries during the 1970s when world oil prices rose sharply, leading to the birth of the Misery Index.

The Misery Index, or the total of the inflation rate and the unemployment rate combined, functions as a rough gauge of how badly people feel during times of stagflation. The term was used often during the 1980 U.S. presidential race.

There are two main theories about what causes stagflation. One theory states that this economic phenomenon is caused when a sudden increase in the cost of oil reduces an economy's productive capacity. Because transportation costs rise, producing products and getting them to shelves gets more expensive, and prices rise even as people get laid off.

Another theory posits that inflation is simply the result of poorly conceived economic policy. Simply allowing inflation to go rampant, and then suddenly snapping the reins, is one example of a poor policy that some have argued can contribute to stagflation. Others point to the harsh regulation of markets, goods, and labor combined with allowing central banks to print unlimited amounts of money.

Special Considerations

Stagflation is believed to be an unnatural occurrence in a weak economy because slow growth leads to consumers spending less whereby the decrease in demand prevents prices from rising. Therefore, stagflation is only a result of ill-conceived government intervention.

President Nixon implemented three policies, known as the Nixon Shock, which further worsened the economic situation in the 1970s and led to stagflation.

With a deeper understanding of monetary policy, it is believed that stagflation will most likely never occur again in developed economies. It is true that during times of economic crisis, governments implement expansive monetary policies with the risk of causing inflation, however, the Fed no longer utilizes stop-go monetary policies, such as increasing and decreasing the Fed funds rate. It sticks to a specific monetary direction and ensures that inflation won't go above 2%.

Another cause of stagflation in the 1970s was wage and price controls. This helped increase unemployment because companies could not increase prices on their products or reduce the wages of employees and so were left with the only option of laying off workers. A policy like this would not even be considered today, further cementing the belief that stagflation is unlikely to occur again.