Stagflation is a rare economic phenomenon. It has an effect on your investments and the economy itself. You hear the term stagflation regularly, but what is it, how does it work and what does it do? In this article Alphastocks about the concept of stagflation.
What is stagflation?
Stagflation is a term used to describe an economy experiencing significant inflation, high unemployment, and slow to no economic growth. The 1970s and 1980s saw periods of stagflation in most major economies. This surprised economists, because the dominant economic theory of the time held that increases in inflation and unemployment could not occur simultaneously.
This was based in part on the Phillips Curve, an economic model used to show that there was an inverse relationship between unemployment and inflation. Economists have since identified many potential factors influencing stagflation, including a sudden supply shock and damaging government policies.
What causes stagnation?
The causes of stagflation are heavily debated by economists, as mainstream economic theory before the stagflation-fueled 1970s did not believe it was possible, as the Phillips Curve supported the theory that unemployment and inflation were inversely related. However, economists have proposed a number of theories about the causes of stagflation.
1. Supply Shock
The supply shock theory states that stagflation occurs as a result of a sudden drop in the supply of a service or good. This causes prices to rise dramatically, reducing the profit margins of most companies and slowing economic growth.
2. Bad monetary policy
According to the bad policy theory, stagflation is often the result of bad economic policy. The central bank and government’s attempt to regulate the economy often leads them to make the wrong choices
3. Differential Accumulation
Differential accumulation, a theory of the economists Jonathan Nitzan and Shimshon Bichler, argues that there is a link between mergers and acquisitions, stagflation and globalization. Similar to supply shock theory, they argue that differential accumulation encourages mergers and acquisitions, reducing the power to limit the supply of commodities and accumulated capital and increasing the risk of stagflation.
4. Demand Pull
The demand-pull stagflation theory proposed by the economist Eduardo Loyo states that stagflation can only arise from monetary shocks without the need for a supply-related shock. This happens when governments institute monetary tightening, such as an increase in the federal interest rate or a reduction in the money supply.
5. Cost push
The cost-push inflation theory sees supply-side inflation as a major cause of stagflation. In this case, rising prices lead to unemployment because they usually reduce firms’ profit margins, leading to reduced economic output. Supply-side inflation can also be affected by things like rates, wage increases, or labor shortages.
6. End of the Gold Standard
Historically, Nixon’s termination of US dollar convertibility into gold, which heralded the end of the Bretton Woods system, has been seen as one of the causes of the stagflation of the 1970s.
Bottom line
Economists have long struggled to understand what causes stagflation and how best to intervene when it happens. While many theories exist, they are heavily disputed. Stagflation is a challenging problem, making it difficult for central banks and policymakers to respond effectively. Investors concerned about the effect of stagflation on their portfolios may want to adjust their investment strategy or decide to continue investing in blue chip stocks in key sectors with stable earnings that are likely to weather stagflation or recover quickly.
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