44. What is stagflation and why does it have a negative impact on the market?

Understanding basic economic issues is very important in our lives. It will make it easier for us to make financial decisions and broaden our horizons related to the monetary economy.

In today’s lesson, we will focus on a detailed explanation of what stagflation is. Have you ever encountered this term in your life? Do you know what its causes are and why it has a negative impact on the market? Read on for the answers to these questions!

What Is Stagflation?

This is an economic cycle that is characterized by very slow economic growth and a high unemployment rate. Stagflation and the whole process is accompanied by inflation. According to economic experts, the combination is difficult to control. Why? Because any attempt to correct one of the factors that contribute to stagflation can exacerbate the others.

Interestingly, back in the day, stagflation was considered impossible by economists. Despite this, it appeared in the markets repeatedly and even in highly developed countries. The beginnings of stagflation have been recorded since the oil crisis in the 1970s.

The term “stagflation” itself was first used by British politician Iain Macleod, during his speech to the House of Commons in 1965. It was a period of economic stress in the UK. Where did the idea for the term come from? The politician combined the effects of inflation and stagnation into one word.

The word came up again in the 1970s, during the aforementioned oil crisis in the US. At that time, stagflation caused negative GDP growth for five consecutive quarters.

The effects of stagflation can be vividly illustrated through the utilization of the misery index, which combines both the inflation rate and the unemployment rate. This index serves as a tangible measure that captures the true impact of stagflation on individual countries, evoking a sense of dismay and concern.

How Does Stagflation Work?

As we said, stagflation is influenced by three economic factors: stagnation, high inflation and high unemployment. In stagnation, slow economic growth causes high unemployment. With a lot of people looking for work, we have lower wages. Add to that inflation, which causes prices to rise in the market, which at the same time reduces the purchasing power of consumers.

At such a moment in the market, investors also suffer losses. You will probably ask – why? Because stocks and bonds perform worse during stagflation. Lack of economic growth affects stock prices, while high inflation affects bonds.

What Are the Reasons for Stagflation?

And here we have several versions, for every economist has an opinion. There is no clear-cut position among them. Nevertheless, over the years they have put forward some of the most plausible arguments.

Opinion one: Stagflation can be caused by oil price spikes. This has been noted especially in the American market. In the US, a sudden increase in the cost of oil reduces the productive capacity of the economy. The best example of this is the oil crisis of the 1970s. How did this happen? In 1973, the Organization of Petroleum Exporting Countries (OPEC) imposed an embargo against Western countries. This caused oil prices to soar around the world. Thus, the cost of goods and unemployment rose. And here a cause and effect sequence occurred. As transportation costs increased, making products and getting them to store shelves became more expensive. Prices rose even as people lost their jobs.

Opinion two: Bad economic policy. According to this theory, the combination of stagflation and inflation is attributed to poor economic policy. Specifically, the theory highlights the role of stringent and often unreasonable regulation of markets, commodities, and inflationary labour as the primary cause of stagflation.

Opinion three. Monetary factors. Lack of currency backing in commodities results in restrictions on monetary expansion and currency devaluation.

To reach a real consensus on the concept of stagflation, economists would have to redefine the term inflation. In particular, take into account modern monetary and financial systems. In practice, economists and politicians assume that prices will rise anyway. They focus on the acceleration/deceleration of inflation, not on inflation itself.

How to Prevent Stagflation?

Here, too, there is no clear answer. Admittedly, economists agree on one thing – in such a situation, it is necessary to increase economic productivity enough to lead to higher economic growth without causing inflation to rise. These measures simultaneously enable the tightening of monetary policy and the reduction of the inflationary component of stagflation.

Unfortunately, it is easier said than done to put the above measures into practice.

Summary

There are several other economic factors contributing to stagflation. Unfortunately, there is no cure for it, and there are many causes for its occurrence.

At the macroeconomic level, economists can only encourage policymakers to take effective and rational anti-stagflation measures. Policies aimed at economic growth and productivity are also helpful in combating stagflation.