Stagflation

What is "stagflation"? Stagflation is an economic condition with persistent high inflation combined with high unemployment and relatively stagnant demand for products. Let's take a closer look.

Causes of stagflation are not well understood, but economists believe it's linked to a supply shock resulting in a rapid increase in prices or government policies that increase the money supply too quickly. Typically, high levels of inflation are correlated with lower unemployment rates. But with stagflation, unemployment and inflation are high.

A famous example of stagflation in modern economic history occurred in the 1970s and early 1980s in the United States. Inflation was increasing through the 1970s, but by the time we got to the late 1970s it was no longer helping to reduce unemployment, so we got stagflation -- high inflation and unemployment together. Then, in the early 1980s under Ronald Reagan, inflation fell. Unfortunately, it came hand in hand with a very serious recession in 1981 and '82.

So we can see that getting out of stagflation is difficult because monetary and fiscal policy are not very effective at fighting supply shocks. Even if the cause is not a supply shock, policy can't fight both unemployment and inflation at the same time. Policies aimed at lowering inflation in the long run will typically increase unemployment in the short run, and policies aimed at lowering unemployment in the short run translates to even higher inflation in the long run.