The Problem of Stagflation: stagnant economic output and high price inflation can coexist
- The prevailing notion among economists: an economy can either experience high price inflation or stagnant economic output, but never both at the same time.
- It refers to an economic situation marked by stagnant economic output and high price inflation.
- The idea became popular during the 1970s when the U.S. economy witnessed high price inflation due to the oil shock and economic recession.
- Economists at the time could not explain the prevalence of high price inflation and stagnant economic output at the same time.
Inflation and Unemployment
The idea of stagflation is closely linked to the Phillips curve.
- Inflation is supposed to be maintained at a certain level such that there is no excess unemployment and the economy is functioning at its full capacity.
It tries to establish that there was a negative empirical relationship between unemployment and inflation.
- when unemployment is high, inflation is low and when unemployment is low, inflation is high.
- This relationship was explained by Keynesian economists as a natural phenomenon caused by the prevalence of sticky prices.
- Unemployment in an economy rises when wages fail to drop quickly enough to adjust to changing economic conditions.
- Workers are unwilling to accept a cut in their wages, Businesses lay off some of their employees to adjust to higher wages.
- This can affect the overall output of an economy as fewer people are now employed.
- Many economists believed that it was the duty of central banks to carefully manage price inflation and check unemployment is within reasonable limits.
- Workers could be tricked into accepting lower real wages (but higher nominal wages) when prices rise at a certain rate.
Rational expectations model
There was a need for alternative economic models which explain the stagflationary environment of the 1970s better than the Keynesian model.
- The rational expectations model was one of the alternative models proposed to explain stagflation.
- According to this model, workers could not be as easily tricked by central banks as assumed by Keynesian economists.
- The proponents argued that when workers observe prices rise at a certain rate, they are likely to demand higher wages in order to beat price inflation.
- In that case, central banks cannot trick workers so easily and high inflation and high unemployment may prevail at the same time.
Economists from other schools of thought have also tried to independently explain stagflation.
- Even though prices may be sticky and inflation could trick some workers, the economy does not function in a mechanistic way. (assumed by the Keynesians)
- Keynesians view price rise only after the economy reaches full employment.
- No valid reason to believe why prices cannot rise at an aggressive rate while the economy is stagnant.
- Price rise could be aggressive when a supply shock is met with ultra-loose central bank policy.
- The result could be stagnating economic output even as prices of goods rise aggressively due to rising money supply.
- Keynesian economic model
- Rational expectations model