What is stagflation and what causes it?

What is stagflation and what causes it?

What is stagflation in the economy?

Stagflation is just a combination of the words 'stagnation' and 'inflation' and describes an economy that suffers from limited or negative growth (often with rising unemployment) and rising inflation - as discussed in our previous article about inflation, we know that inflation is a period of rising prices due to more money being in the financial system. 

What is stagflation?

Economic theorists and politicians had long thought the conditions for stagflation to occur were impossible as there was a belief that inflation is intrinsically linked to employment. Essentially, the rule of thumb at the time was that with rising employment levels (a result of economic growth) comes rising prices in the form of inflation and vice versa (reduced employment means reduced inflation).

Following the great depression in the early part of the 20th century, economic theory was most concerned with avoiding deflation (reducing prices) and it was argued that any attempts made to reduce inflation made it more difficult to increase employment and that any attempts to increase employment resulted in inflation. As a result, politicians have made policies to avoid deflation and therefore keep inflation at a steady, constant level.

However, the term 'stagflation' was first coined here in the UK in the 1960s and was used by a politician in the House of Commons when discussing the situation when the impossible became possible - both a stagnant economy and rising prices. It has since been used to describe the economic conditions during the oil crisis of the 1970s in the USA and is being used now to describe the situation in the UK thanks to issues including soaring energy prices, global supply chain problems and the Russian invasion of Ukraine.

What causes stagflation?

Given that the conditions for stagflation are actually possible, economic theorists have since sought to redefine what causes the economic conditions necessary for stagflation. Which include:

• Moving away from the Gold Standard.

• The impact of oil prices on the economy.

• The impact of monetary policy.

Moving away from the Gold Standard. 

As we discussed in our article on Gold, we know that the original gold standard meant that most currencies could be converted to a certain weight of gold and as a result, the exchange rates between currencies were fixed. This meant that governments had to keep enough physical gold reserves to support the amount of currency that had been issued. 

However, after the Bretton Woods meeting in 1944, it was decided that the US dollar and the federal reserve would be at the centre of the world economic system and it was decided that gold would be worth $35 per ounce, whilst other countries around the world had fixed but adjustable exchange rates to the dollar - giving nations the power to stimulate their economies without suffering penalties. 

Unfortunately, the world's preoccupation with avoiding deflation meant that by the 1960s, global inflation resulted in the price of gold being too low and the levels of international gold reserves became inadequate. After several attempts to keep the US Dollar pegged against gold, in 1971 President Nixon ended the on-demand convertibility of dollars into gold and the Bretton Woods system collapsed, allowing gold to be traded freely on the world's markets. 

This movement away from a gold standard meant that currencies were now in a fiat system (currency issued by a government that is not back by a physical commodity) and there were no restraints on the amount of money that could be printed for the purpose of economic growth and therefore increasing inflation. Essentially, the more money there is, the less it is worth. 

The impact of oil prices on the economy.

It is believed that a sudden increase in the oil price will reduce a nation's ability to grow. As we know in the current times of record fuel prices; some companies are shutting down production as the cost of production has become so great that the market cannot afford the increase in prices. This also applies to food which is heavily affected by the price of the fuels and fertiliser required to grow, process and deliver it. 

The impact of monetary policy on the economy.

There is always a case to blame politicians for the decisions they make. Whether it is the process of 'quantitative easing' and issuing new currency to keep an economy growing (but devaluing the existing supply of money in the process) or putting restrictions on employers with rules, restrictions and taxes (such as using overseas labour or increasing corporation tax), governments really need to consider every eventuality before implementing policies.

Why is stagflation seen as a bad situation?

Slow economic growth usually results in rising unemployment but not rising prices as fewer jobs result in less consumer spending. However, if you add rising prices to rising unemployment, the pressure put on consumers increases dramatically.

How does a government fix stagflation?

The best thing for any government to do is to avoid stagflation in the first place. However, it is thought that supporting growth without causing inflation, via a relaxation in regulation and reduction in the money supply, for example, could be a solution.

Conclusion.

Stagflation is something that could heighten the effect that rising inflation is already having on the way we spend, save and invest. In times of stagflation, business and individuals need to think very carefully about all their buying and selling decisions.

Don’t forget to read What is inflation and how does it affect my money? and you can also check our UK Salary and Wage Inflation Calculator to see how much your pay increase needs to be to keep pace with inflation.

Finally, you can read the Bank of England’s view on the current inflation rate in the UK.

What’s next?

If you need help or advice on your personal or business finances or if you want to consider investing to make your money work harder, you can get in touch with one of our advisors for independent financial advice. We offer a free initial consultation and although we are based in Tunbridge Wells, we advise clients across the UK.

Don’t forget, this article offers information about investing and should not be taken as personal advice. Remember that investments and pensions can go up and down in value, so you could get back less than you put in. Tax rules can change and the benefits depend on individual circumstances.