Stagflation, as the name suggests, is a unique situation wherein high inflation rates are coupled with a stagnant economy with low income and employment rates.
The term is generally attributed to Iain Macleaod, a British politician who used the term during a parliamentary speech in 1965. The term created an economic storm, as postwar macroeconomic theories stated that inflation and recession were diametrically opposite. Inflation was often a result of high growth coupled with increase in income and correspondingly demand, thereby hiking up prices. Stagnation, on the other hand was a result of low demand and prices, eventually leading to collapse.
There are a few economic theories which explain possible reasons for stagflation. According to one theory, stagflation can be the fallout of a form of supply side hazard, an example being sudden increase in oil price in an oil importing country. Increase in fuel prices usually govern corresponding rise in other commodity prices, gradually causing inflation.
Oil being a major commodity in most production activities, would cause an overall increase in cost structure of all manufacturing units. This leads to lower profitability and hence lower production. Thus the combined effect of price rise and production fall causes stagflation.
Stagflation can also be caused by mismanaged macroeconomic policies. The monetary authorities can increase money supply in a bid to increase demand and provide a spurt to the economy.
Such an action is bound to increase prices. If such an increase in money supply is not thoroughly complemented with liberal policies in the goods and labor market, then this would lead to decrease in production. If such a situation is sustained over a prolonged period, it could cause stagflation.
The world wide stagflation during the 1970s began with a substantial rise in oil prices, and was fueled further by an expansionary monetary policy followed by central banks of most economies. Stagflation is an economic worst case scenario and it could take several decades for affected economies to recover.
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