Stagflation Explained: What Causes Stagflation?

Stagflation is a term used in macroeconomics to describe an economic situation wracked by three factors:

1. 1. High inflation: Inflation occurs when the purchasing power of money diminishes (reflected in rising consumer prices). In the United States, economic policymakers often use a metric called the consumer price index (CPI) to measure inflation rates.
2. 2. High unemployment: Unemployment rates vary by country, but two relatively recent spikes for the U.S. economy came in 2009 when the unemployment rate reached 9.9 percent and in 2020 when unemployment briefly peaked at 14.7 percent. During the Great Depression, unemployment peaked at 24.9 percent.
3. 3. Slow economic growth: Economists track the country's gross domestic product (GDP) to chart an overall economic growth rate. In the United States, conventional economic policy wisdom is that the economy should grow at a rate of roughly two percent every year.

Traditionally, the economic phenomenon known as stagflation has been brought on by two converging factors.

1. 1. Supply shocks: When the price of a key commodity rises sharply and out of sync with the rest of the economy, it can disrupt many other downstream economic metrics. The infamous stagflation of the 1970s was propelled by supply-side shocks in oil prices thanks to the 1973 OPEC oil crisis and subsequent downstream effects.
2. 2. Surges in aggregate demand: A sudden increase in aggregate demand can overwhelm supply chains and create inflationary outcomes. Sometimes this surging demand traces back to a government's monetary policy, which is controlled by the U.S. Federal Reserve (or "the Fed"). Other times, the price of goods rises when consumers shift their spending from services to physical goods.

Keynesian economists, monetarist economists, and neoclassical economists rarely agree on the role governments should play in balancing forces of inflation and deflation, yet all three have somewhat similar views on the root causes of stagflation.

1. 1. Keynesian approach: Keynesian economics, named for English economist John Maynard Keynes, is built on the notion that governments can and should influence job creation and ward off economic downturns by making proactive adjustments to national economies. This can come via adjusting interest rates, buying and selling bonds, and raising or lowering taxes. Keynesians see stagflation as the result of cost-push inflation, which means that the cost spikes in key commodities—notably essentials like fuel and shelter—lead to higher inflation throughout the economy.
2. 2. Monetarist approach: Monetarism, as espoused by conservative economist Milton Friedman, argues that inflation is independent of employment. Monetarists have argued that when employees sense that inflation will be long-term, they negotiate higher salaries, which increases a business's cost of production, which in turn leads to the business raising prices. This creates a spiral of inflation, which occurs whether employment rates are high or low. Per monetarist theory, when inflation spirals happen to correspond with high unemployment, stagflation occurs.
3. 3. Neoclassical approach: Neoclassical economists segregate the root causes of unemployment and inflation. They see unemployment as solely linked to an economy's aggregate supply (do the number of jobs roughly match the number of job seekers) and inflation as solely linked to aggregate demand (can existing supply chains meet consumer demand). In the 1910s, Keynes himself (although not a neoclassicist) made classical economic arguments for how governments could inhibit economic growth by instituting price controls yet also foment inflation by printing too much money.

For many living Americans, the most visceral historical example of stagflation occurred in the 1970s. Many factors contributed to the multi-year conundrum, but chief among them was a 1973 OPEC oil embargo that kicked off many years of energy constrictions and rising prices. Concurrently, the Federal Reserve pushed low interest rates to counter multiple recessions; this expanded the nation's monetary supply, which aided the stock market, but it did not lead to job creation. Unemployment remained persistently high throughout the decade as many blue-collar industries constricted their U.S. operations. Eventually, the persistent stagflation was broken by the U.S. Federal Reserve chairman Paul Volcker, who drastically raised interest rates as he pursued a government policy known as disinflation.

Other examples of stagflation have popped up in the United Kingdom in the 1960s and (in some economists' estimates) in Russia in the 1910s around the time of the Russian Revolution. For stagflation to occur, high inflation, economic stagnation, and high unemployment must all exist concurrently.

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