Stagflation in the Economy?
Currently, there is a huge debate about whether the Covid-19 induced economic crisis has pushed the major economies to stagflation. The debate is getting stronger in India, with the release of GDP data for the first quarter of FY21. But what exactly is stagflation? What are the main causes and why is it so dangerous?
What is stagflation?
Stagflation was first recognized during the 1970s when many developed economies experienced rapid inflation and high unemployment as a result of an oil shock. Stagflation is a period of rising inflation along with falling output and rising unemployment. As a result, real incomes fall as wages struggle to keep up with rising prices. It can also be defined as a period of inflation in addition to a decline in the gross domestic product (GDP).
The term stagflation, a portmanteau of stagnation and inflation, was first used during a period of inflation and unemployment in the United Kingdom in the 1960s and 1970s. UK policymakers failed to recognise the primary role of monetary policy in controlling inflation. Instead, they attempted to use non-monetary policies and other devices to respond to the economic crisis. They also made incorrect estimates of the degree of excess demand in the economy, which contributed significantly to the outbreak of inflation in the United Kingdom during that period.
What causes stagflation?
One of the main characteristics of stagflation is slow economic growth and relatively high unemployment—or economic stagnation—along with rising prices (i.e. inflation). Generally, stagflation occurs when the money supply is expanding while the supply of output is being constrained.
Economists have given 2 principal explanations for why stagflation occurs. First, an economy facing a supply shock, such as a rapid increase in the price of oil, can result in stagflation. An unfavourable situation like this tends to raise prices while concurrently slowing economic growth by making production more costly and less profitable. Second, if the government creates policies that harm the industries while growing the money supply rapidly, it can lead to stagflation. These two things would probably have to occur simultaneously because policies that slow economic growth do not usually cause inflation, and vice versa.
Some of the factors resulting in stagflation can be:
Oil price rise: Stagflation is often a result of a supply-side shock. For instance, a rise in business costs (transport becoming more expensive) due to rising commodity prices, such as oil prices, will result in the short-run aggregate supply curve shifting to the left. This causes an increase in the inflation rate and a decrease in total output.
Powerful trade unions: If trade unions have good bargaining strength, they can bargain for higher wages, even when the economy faces lower economic growth. Higher wages are a significant cause of inflation.
Falling productivity. If an economy experiences falling productivity, i.e. workers become more inefficient; then more workers will be required to produce the same level of output, leading to increased costs and relatively lower output.
Rise in structural unemployment. If there is a decline in traditional industries, we may get more structural unemployment and lower output as the demand for labour decreases. Thus a higher level of unemployment will be possible even if inflation is also on the rise.
Supply shocks. If there is a disruption to supply chains, the prices will start rising. The supply shock will also cause a decrease in unemployment. For instance, in the year 2020 when the government of India declared lockdown due to the outbreak of Covid-19, there was a huge impact on the supply chains resulting in a rise in prices.
Why is stagflation bad?
Stagflation is a contradiction as slow economic growth could lead to an increase in unemployment but should not result in rising prices. An increase in the unemployment level results in reducing the consumer spending power as wages will be on the decline. If there is a situation of hyperinflation along with high unemployment, this means that what money consumers have is losing value as time passes and there is less money to spend.
Is India facing stagflation?
The Indian economy contracted 23.9 per cent in the first quarter of FY21. The major components of GDP -- viz consumption demand and investment demand – reduced by 27 per cent and 47 per cent, respectively. On the other hand, the inflation rate as measured by Consumer Price Index (CPI) crossed the upper limit of 6 per cent set by RBI for the fifth consecutive month at 6.69 per cent in August 2020. The contraction of GDP along with the rising inflation rate creates a tension of stagflation in the Indian economy.
What is the solution?
There are no easy solutions to stagflation.
Monetary policy can generally be used to reduce inflation (by increasing interest rates) or increase economic growth (by decreasing interest rates). However, it cannot solve both inflation and recession simultaneously.
Reducing the economy’s dependence on oil can be one solution to make the economy less vulnerable to stagflation as volatility in oil prices is among the major causes of stagflation.
Many economists argue for supply-side policies to increase efficiency and reduce costs of production, which enables higher growth without inflation.
Free-market supply-side policies include policies to create a rise in competitiveness and free-market efficiency. Some examples are privatization, deregulation, lower income tax rates, and reduced power of trade unions.
Interventionist supply-side policies include government intervention to overcome market failure. For example, higher government spending on transport, education and communication.
References:
https://www.economicshelp.org/blog/glossary/stagflation/
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