We asked Veronika Dolar, an economist at SUNY Old Westbury and visiting professor at Stony Brook University, to explain stagflation, what causes it and why presidents and policymakers hate the phenomenon.
Each measure tells its own important story about how the economy is doing. GDP – or the total output of all good and services produced – shows us what the broader economy is doing, unemployment tells us about the job situation, and inflation measures the movement of prices.
But their stories also overlap. And unfortunately, they usually don’t all tell us good news at the same time.
Under normal circumstances, there are trade-offs. You usually can’t have a strong pace of GDP growth and low unemployment without suffering the pains of higher inflation. And if you’re able to keep inflation low, that usually comes at the expense of subdued GDP and possibly higher unemployment.
So, normally there is some good news and some bad news. But with stagflation, there is no good news.
Stagflation happens when the economy is experiencing both economic stagnation – stalling or falling output – and high inflation. Additionally, a struggling economy will drive up unemployment.
In other words, all three macroeconomic indicators are going in the wrong direction.
The same events – OPEC pushing up prices, inflation soaring, economies sinking into recession – repeated just a few years later. Over this period, rising unemployment and reduced business activity meant everyone had less money, yet surging inflation meant every dollar was worth a little bit less every day.
The most common is that stagflation happens when there is a so-called negative supply shock. That is, when something that is crucial to an entire economy, such as energy or labor, is suddenly in short supply or becomes more expensive. One obvious example is crude oil.
Oil is a key input into the production of many goods and services. When some event, like the Russian invasion of Ukraine, reduces the supply, the price of oil rises. Businesses in the U.S. and elsewhere that produce gasoline, tires and many other products experience rising transportation costs, which makes it less profitable to sell stuff to consumers or other companies no matter the price.
As a result, a great number of producers decrease their production, which decreases aggregate supply. This decrease leads to falling national output and an increased unemployment rate together with higher overall prices.
Can the US do anything about it?
For policymakers, there’s almost nothing worse than the specter of stagflation.
The problem is that the ways to fight either one of those two problems – high inflation, low growth – usually end up making the other one even worse.
The Federal Reserve, for example, could raise interest rates – as it’s widely expected to do on March 16, 2022 – which can help reduce inflation. But that also hurts economic activity and overall growth, because it puts the breaks on borrowing and investment. Or policymakers could try to spur more economic growth – whether through government stimulus or keeping interest rates low – but that would likely end up fueling more inflation.
Put another way, you’re damned if you do, damned if you don’t. And that means solving the problem may simply depend on circumstances out of U.S. policymakers’ control, such as an end to the crisis in Ukraine or finding ways to immediately increase oil supply – which is tricky.
In other words, stagflation is a nightmare you never want to live through.
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Veronika Dolar does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.