Stagflation: Causes, Effects, and How to Combat It


March 31, 2023

Stagflation: Causes, Effects, and How to Combat It

March 31, 2023

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What Is Stagflation?

Stagflation may sound like a buzzword, but it is a very real cycle characterized by slow or stagnant economic growth combined with high inflation and a sharp rise in unemployment. This combination of factors can lead to a decrease in living standards and confidence in the economy. Stagflation is a hybrid of stagnation and inflation. It is a difficult situation to remedy since it involves both economic contraction and rising prices – and attempts to address one can exacerbate the other.

A stagflation scenario was once thought to be impossible by economists, but it has happened twice in the U.S. since the 1970s – once between 1974 and 1975, and again between 1978 and 1982. According to Fortune, these scenarios occurred in a period known as the Great Inflation, during the 1970s oil embargo crisis, when the U.S. experienced negative GDP growth over five consecutive quarters (1965 to 1982).

This article discusses the causes of stagflation, its effects, how it can be addressed, and how it relates to other economic issues.

Causes of Stagflation

There has yet to be a concrete consensus among economists on what exactly causes stagflation, but supply chain issues, poor governmental economic policies, and oil price volatility are among some of the commonly suggested causes. The following factors can also contribute to the economy reaching a state of stagflation:

  1. A decrease in demand due to diminishing consumer spending, which can be caused by wage decreases, tax increases, or decreases in business investments.
  2. An increase in the cost of production, which can be caused by price increases of raw materials, increased labor costs, or increased government regulations.
  3. A decrease in the money supply, which can be caused by changes in government monetary policy or by a decline in investors’ confidence due to increased interest rates or other policies that can affect their bottom line.

Effects of Stagflation

Stagflation combines three negative economic effects: high unemployment, high inflation, and slow economic growth. During a period of stagflation, the price of goods and services increases, and businesses are likely to cut back on hiring and lay off workers to save money. Wage decreases may also occur, which means workers have less money to spend on the goods and services that have had price increases.

Another effect of stagflation is a decrease in investing. Per Fortune, “Investors see lower returns due to slow growth, and the longer stagflation continues, the more it impacts the future value of their investments.” As a result, businesses are less likely to invest in new projects or hire new workers, as they are uncertain about the future of the economy. This can lead to decreased economic growth, further exacerbating stagflation.

Stagflation can also lead to a decrease in the standard of living because the prices for goods and services can increase faster than wages. This means that households have less money for both staples and discretionary spending. Economists have gone so far as to create a misery index – an indirect measure of the level of economic distress a person feels calculated by adding the seasonally adjusted unemployment rate to the inflation rate.

How to Address Stagflation

Stagflation can be challenging to address, as it involves both contraction and rising prices, i.e., inflation and recession. In addition, efforts to combat one factor generally exacerbate the others; fighting slow economic growth can increase the inflation rate and vice versa.

Per Investopedia, typically, during inflation, “Governments respond to recessions through expansionary monetary and fiscal policies.” The government simply pumps more money into the economy and encourages businesses to grow and hire new employees. During a recession, “The government restricts the supply of money in the system to make it more expensive to borrow. Businesses and consumers borrow less and spend less. The overall economy slows down. With demand declining, prices stop rising.” But things get more complicated when both inflation and recessionary pressures are happening simultaneously.

Economists have varying ideas on how economies can address stagflation. Ideally, there would be an increase in demand, a reduction in the cost of production, and an increase in the money supply: however, those are no easy feats. As policymakers try to address stagflation, you can consider doing the following:

  1. Reducing your debt
  2. Delaying major purchases until the economy improves
  3. Keeping your job, as new jobs may be hard to come by
  4. Reassessing your investment portfolio allocations and adding more exposure to assets that perform well in a stagflationary environment and aren’t as sensitive to rising interest rates because of inflation.
  5. Buying Treasury Inflation-Protected Securities (TIPS) – government bonds that mimic the rise and fall of inflation

Takeaways

Stagflation is characterized by slow economic growth, high unemployment, and high inflation; its effects on the economy and standard of living can be severe. While policymakers work to combat stagflation, don’t panic. There may be actions you can personally take to reduce its impact on your finances and well-being.


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References

Investopedia Team. (July 31, 2022). What Is Stagflation, What Causes It, and Why Is It Bad? Investopedia. https://www.investopedia.com/terms/s/stagflation.asp

Probasco, Jim. (December 28, 2022). Stagflation: When a stalling economy, high inflation, and rising unemployment all collide. Fortune. https://fortune.com/recommends/investing/what-is-stagflation/ 

Ross, Sean. (March 04, 2021). How to Control Stagflation. Investopedia. https://www.investopedia.com/ask/answers/040615/what-actions-or-policies-can-government-agency-take-counteract-and-end-stagflation-economy.asp