Stagflation

Stagflation is a combination of inflation and little or no economic growth with increasing unemployment.Inflation,unemployment and economic growth are outcomes of the relationship between aggregate supply and demand in the economy. When demand exceeds supply, prices increase and inflation occurs. Conversely, demand being less than supply can lead to unemployment and a recession.


Traditionally it has been assumed that high employment goes hand in hand with inflation given the theory than high employment raises demand. This is defined in the Phillips Curve shown in the figure below.

Stagflation has been a real life event in some national economies and some theories suggest that it is a result of inappropriate government policy. The supply shock theory gives an example of how stagflation occurs. A highly prized commodity(say oil) suffers from a reduced supply thus driving its price up. The economy tries to maintain the same momentum it was experiencing before this shock by paying higher prices in an attempt to maintain the level of demand.

The central bank in a real world economy can take action in view of these events and often provide an economic stimulus in an attempt to prevent a recession. One monetary policy would be a cut in interest rates in a bid to raise aggregate demand as we have seen recently by the Fed. The increased money supply in the economy then drives demand. Higher prices from the demand should cause a balancing increase in supply but the supply shock makes this an impossibility.

In order to incorporate stagflation into the PC model we have to introduce the possibility of a supply event which causes a (monetary policy or money supply) reaction if supply of the commodity(say oil) drops below a ‘balanced’ level. This supply drop needs to be introduced to the model as a "shock" variable. This shock variable will influence the relationship between supply and demand ensuring that increased demand is not always met by a corresponding supply. The PC model represents a demand led economy i.e. whatever is demanded is supplied. In the case of a severe supply shock the economy will become supply led and the shock will result in cost push inflation. Any increases in the money supply in this case will only increase inflation further.

This increased inflation will increase the costs of production and workers will demand a higher wage rate. Higher wages and costs of production will reduce economic growth.

The magnitude of this shock variable will also have an influence on how quickly the economy can recover from this stagflation and return to normal levels. In essence, the greater the shock the greater the ripple effect.

References
1)http://www.jstor.org/view/03170861/ap060028/06a00070/0?frame=noframe&userID=c101646d@ul.ie/01c0a8347100501c23972&dpi=3&config=jstor
2)http://www.oup.com/uk/orc/bin/9780198776222/carlin_chap11.pdf
3)Antitrust law, competition and the macroeconomy, Peter C Carstensen