Stagflation is a made from joining two word – Stagnation and Inflation. A country is said to be in stagflation when it is facing slow growth, reflected by high unemployment (stagnation) along with a rise in prices (inflation).
Typically, when there is a slowdown in the economy, unemployment is high, consumer demand is low and prices fall (level of inflation comes down). On the other hand, when the economy is growing, it is usually accompanied with moderate levels of inflation. This makes Stagflation a unique occurrence as slow economic growth and high unemployment is coupled with high inflation.
Why is Stagflation Bad?
For general public, due to high unemployment rate, there are more workers looking for jobs than the jobs available. In more formal terms, the supply of labour is greater than the demand of labour. Multiple workers, bidding for the same job, will bring the wages down, as each person would be willing to work for slightly lower wages. As a result, purchasing power of people goes down. This is further coupled by increase in prices (since inflation is high), resulting in a double whammy.
For policy makers, controlling stagflation is tough as the tools that they use to bring down inflation, are said to have a negative impact on unemployment and vice versa.
A brief explanation on how inflation and unemployment move in different directions:* To control an increase in inflation, the central bank would increase the interest rate at which it lends to commercial banks (called the Repo Rate). A rise in interest rate, will lead to lower investments in the economy and hamper the economic growth, thereby leading to a slowdown and higher unemployment. Hence tools used to control inflation lead to higher unemployment.
On the other hand, when unemployment is high, the policymakers would want to stimulate the economy. This is typically done by increasing the government spending (say on large infrastructure projects) and reducing the tax rate (so that people have more after-tax income in hand and are able to spend more). While this would lead to an increase in goods and services produced in the country and thereby reduce unemployment, there is a limit to which production of goods and services can be increased. Once this limit is reached, these stimulating policies will only lead to an increase in inflation. Thus, what started out as a mission to reduce unemployment might inevitably lead to an increase in inflation.
As these two forces tend to move in opposite direction (in the short run), it becomes hard for policy makers to control stagflation.
Is There Any Country That Has Faced Stagflation?
Examples of Stagflation are very limited. The classic example of stagflation occurred in US in 1970. This occurred due to high oil prices and oil shortage, resulting in a slowdown in the economy as industrial output took a hit, coupled with high inflation.
*This relationship is complicated and would need a separate post to delve deeper. But to understand the bigger picture, a brief explanation has been attempted.