How does stagflation affect the economy

While inflation fell slightly in September to 3. Meanwhile, interest rates are still at a record low of 0. The aim was to encourage households to spend rather than save cash and get the economy moving.

It would also let businesses borrow money cheaply so they could pay their way through the economic shock. Most recently, on 4 November , the Bank voted to keep interest rates at this historically low level. At the moment, average wages in the UK are climbing as the economy continues to recover from multiple lockdowns.

But at the same time, companies are tackling labour shortages caused by both the pandemic and Brexit. This, along with rising energy and commodity prices, will feed through into inflation.

There are also supply issues confronting some businesses as they look to meet the increased demand while struggling to recruit staff. In a situation like this, the danger is that prices will keep rising over time as supply fails to keep pace with demand. This is perhaps also propped up by low interest rates. But economic output and growth will stay low, households will be able to afford relatively less, and unemployment will be high. Find out more: How to calculate inflation to future-proof your finances.

For a precise definition of stagflation, we need to look at the word itself. Stagnation is exactly what it sounds like: the British economy is not growing. Meanwhile, inflation means goods and services such as food, fuel and clothes are getting more expensive. Conservative politician Iain McLeod, then the spokesperson on economic issues for the party while it was in opposition, coined the term while speaking in the House of Commons in Stagflation is caused by the prices of goods such as medicines, staple foods and energy rising, while overall economic growth is falling.

But stagflation is most noticeable and most drastic when it occurs as a reaction to a large-scale economic shock, like the oil crisis of the s, or the coronavirus pandemic.

Find out more: Calculating inflation to plan for the future. The stagflation of the s forever changed the way that financial officials think about keeping economies stable and in good health. Before this point, it was assumed that periods of high inflation were not a problem. It was thought a growing economy meant businesses would hire more staff to expand, creating more supply to soak up higher demand for goods and services, and therefore curbing price rises.

Inflation was on the rise in most of the developed world, including big economies like the UK and US, in the late s. Then came the oil crisis. The only tradeoff, economists believed, would be a safely rising rate of inflation [source: Concise Encyclopedia of Economics ]. Unfortunately, they got it wrong. The result of unnaturally low unemployment in the s 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 [source: Hoover ]. But the wage-price spiral alone wasn't enough to trigger killer stagflation. The real kicker was the OPEC oil embargo of , 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. In , inflation was 5. By , it was The stock market ground to a halt. But when you subtract for inflation average 7.

The annual return on bonds was 2. President Jimmy Carter and the Fed tried numerous tactics to stabilize the economy, including wage and price guidelines and large government spending and borrowing , both of which only seemed to exacerbate the problem.

In the next section, we'll take a look at how the Fed finally got stagflation under control and how it can be prevented in the future. Economist Milton Friedman was one of the first to predict the stagflation of the s. Friedman understood that the Federal Reserve wields incredible power to increase or decrease inflation in the U.

In Friedman's worldview, inflation happens when the Fed allows too much money to circulate in the economy. His formula for inflation is simple: "Too much money chasing too few goods. The dual mission of the Fed is to keep prices stable and maximize employment [source: Hobson ]. The strategy for achieving this mission is called monetary policy.

Modern monetary policy is heavily influenced by Friedman's theories. When the economy is growing, the Fed raises interest rates to limit the amount of money in circulation. When the economy slows, the Fed lowers interest rates to encourage borrowing and increase the amount of money in circulation.

The goal is to strike a precarious balance where the economy grows at a healthy rate without allowing inflation to get out of control. In the s, in an effort to maximize employment at all costs, the Fed lowered interest rates and flooded the economy with money. This led to increased demand for goods and services and rising prices.

When it was clear in the s that inflation was spiraling out of control, the Fed and the federal government took the erroneous approach of pumping more money into the system even as real economic output sagged. This fit Friedman's formula for inflation: too much money chasing too few goods.

It wasn't until , with the appointment of Fed chairman Paul Volcker, that the Fed put Friedman's monetary policy theory into practice [source: Orphanides ].

Volcker raised interest rates, choking off the flow of money into the economy. It meant high unemployment and a significant recession in the early s, but inflation returned to normal levels and the economy eventually stabilized. The threat of stagflation is greatly increased during a recession, when GDP is slumping and unemployment is on the rise.

The dramatic episodes of stagflation in the s may be a historical footnote today but, since then, simultaneous economic stagnation and rising price levels in a sense make up the new normal during economic downturns. Generally, stagflation occurs when the money supply is expanding while supply is being constrained. Stagflation is a contradiction as slow economic growth would likely lead to an increase in unemployment but should not result in rising prices.

This is why this phenomenon is considered bad—an increase in the unemployment level results in a decrease in consumer spending power. If you tack on runaway inflation, that means that what money consumers do have is losing value as time goes by—there is less money to spend and the value of the money is in decline. There is no definitive cure for stagflation. The consensus among economists is that productivity has to be increased to the point where it would lead to higher growth without additional inflation.

This would then allow for the tightening of monetary policy to rein in the inflation component of stagflation that is easier said than done, so the key to preventing stagflation is to be extremely proactive in avoiding it. An example of stagflation is when a government prints currency which would increase the money supply and create inflation , while raising taxes which would slow economic growth —resulting in stagflation.

Louis Federal Reserve. Congress: Congressional Budget Office. Accessed Sept. Bureau of Labor Statistics. Federal Reserve History.

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