Stagflation is the term used to describe the combination of inflation, low economic growth and rising unemployment levels.
It came to prominence in the 1970’s when the UK and the US both experienced stagflation. The initial cause of this was the oil crisis of the 1970’s which saw world oil prices rise dramatically. In conjunction with this developed countries were experiencing low economic growth. Therefore the inflation associated with the rising prices was not offset by any economic conditions and stagflation arose.
There are two main causes of stagflation:
The first cause occurs when an economy is slowed by an unfavorable supply shock. For example an increase in the price of oil for an oil importing country, tends to raise prices while at the same time it is responsible for slowing the economy by making production less profitable
The second cause can be inapproporiate macroeconomic policies which are responsible for increasing inflation and causing stagnation. For example Central Banks may cause inflation by permiting excessive growth in money supply, and governments may be responsible for stagnation by the over regulation of goods markets.
It came to prominence in the 1970’s when the UK and the US both experienced stagflation. The initial cause of this was the oil crisis of the 1970’s which saw world oil prices rise dramatically. In conjunction with this developed countries were experiencing low economic growth. Therefore the inflation associated with the rising prices was not offset by any economic conditions and stagflation arose.
There are two main causes of stagflation:
The first cause occurs when an economy is slowed by an unfavorable supply shock. For example an increase in the price of oil for an oil importing country, tends to raise prices while at the same time it is responsible for slowing the economy by making production less profitable
The second cause can be inapproporiate macroeconomic policies which are responsible for increasing inflation and causing stagnation. For example Central Banks may cause inflation by permiting excessive growth in money supply, and governments may be responsible for stagnation by the over regulation of goods markets.
In a period of stagflation consumption of goods will remain steady as households will save in order to prepare for more difficult time ahead. Govt expenditure remains the same or decreases in stagflation periods however the govt must try to increase their spending in order to fight the problem of stagflation and try to stop Y from decreasing.
In the PC model the price of bills does not change throughout their duration. This assumption is relaxed in order to allow the Fed to cut interest rates which as we know could be a cause of stagflation. When interest rates are cut, the price of bills will rise causing increases in wealth. This increased wealth will result in an increase in consumption expenditure. (equation5) Therefore, a reduction in interest rates will result in an increase in demand for the short run. The long run outcome of a reduction in interest rates will cause a reduction in long term aggregate income. This is because the lower yields on govt debt reduce the flow of payments from the govt sector leading to less money available to the consumer.
In the PC model the price of bills does not change throughout their duration. This assumption is relaxed in order to allow the Fed to cut interest rates which as we know could be a cause of stagflation. When interest rates are cut, the price of bills will rise causing increases in wealth. This increased wealth will result in an increase in consumption expenditure. (equation5) Therefore, a reduction in interest rates will result in an increase in demand for the short run. The long run outcome of a reduction in interest rates will cause a reduction in long term aggregate income. This is because the lower yields on govt debt reduce the flow of payments from the govt sector leading to less money available to the consumer.
Wikipedia - http://en.wikipedia.org/wiki/Stagflation
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