What Causes Stagflation?

Stagflation is an economic phenomenon that occurs when inflation is high and economic growth is low. No exact percentages exist for this event; it simply requires an upside down set of events that create a negative situation. Two basic situations can create stagflation. The first occurs when an economy experiences a sudden decrease in supply, resulting in high prices that exceed the natural market level. The second situation comes from poor macroeconomic policies, such as money supply or government regulation.

Economies all hinge on the prices associated with goods and services. The price set by sellers is often the production cost of goods plus a percentage of profit. The stability of price comes from the inputs necessary to create the item. A sudden price shock — such as war that restricts the availability of goods or import tariffs that increase costs — can result in high consumer prices. The price increases will often lead to a supply glut as consumers cannot afford the prices for consumer goods and services.

Inflation is present in all economies, even those described as healthy. The most classic definition of inflation is too many dollars chasing too few goods. In healthy economies, growth spurs inflation as more individuals and businesses have the ability to purchase goods and services. This is natural inflation and not seen as negative for an economy when held in check. Unnatural inflation occurs when a government increases the money supply or lowers interest rates to unsustainable levels.

Recessions are often a result of stagflation. When prices are too high for consumers to purchase goods, businesses begin to fail. Unemployment will increase as companies begin laying off workers. This reduces the demand for goods as consumers have less money to spend on goods and services. A government can exacerbate the recession by attempting to loosen the money supply and spur economic growth; however, this leads to inflation and increases stagflation.

To correct the effects of stagflation, businesses need to find alternate sources of production materials or produce substitute goods. Governments need to tighten the money supply and raise interest rates to decrease inflation. These events will often take time and result in a painful recovery period. Unfortunately, there is no quick and easy way to restore an economy back to its regular price levels. Through slow progression and measured steps, a government can return its economy back to a normal level and allow the market to restore the natural prices for goods and services.