Stagflation
GS Paper 3, Economy.
Context:
- Stagflation is an economic state characterised by low economic activity and excessive price inflation.
- The concept gained popularity in the 1970s, when the US economy experienced substantial price inflation as a result of the oil shock, as well as an economic recession typified by negative economic growth. Economists at the time couldn’t explain the simultaneous presence of substantial price inflation and stagnating economic production.
- Back then, economists believed that an economy might have either excessive price inflation or sluggish economic production, but never both at the same time.
Meaning of stagflation:
- Stagflation is characterised by weak economic development and relatively high unemployment—or economic stagnation—along with rising prices (i.e., inflation). It is described as a period of inflation followed by a drop in the gross domestic product (GDP).
Stagflation’s History:
- The Phillips Curve economic theory, which emerged in the framework of Keynesian economics, depicted macroeconomic policy as a trade-off between unemployment and inflation.
- Every proclaimed recession in the United States during the last 50 years has witnessed a year-over-year rise in consumer prices.
- The only exception is the low point of the 2008 financial crisis, and even then, price declines were limited to energy costs, while overall consumer prices other than energy continued to grow.
- The Organization of Petroleum Exporting Countries (OPEC) imposed an embargo on Western countries in October 1973. This led the worldwide price of oil to skyrocket, raising the cost of commodities and leading to an increase in unemployment.
Relationship between Inflation and Unemployment:
- Stagflation is closely related to the Phillips curve, which attempted to show a negative empirical relationship between unemployment and inflation.
- In other words, when unemployment is high, inflation is low, and when unemployment is low, inflation is high, according to the Philips curve.
- Keynesian economists described the alleged negative link between unemployment and inflation as a natural phenomenon induced by the predominance of sticky pricing.
- According to these economists, an economy’s unemployment grows when wages do not fall rapidly enough to react to changing economic conditions.
- Workers are perceived as resistant to accept wage cuts, requiring employers to let rid of certain employees in order to adjust to higher salaries rather than lower earnings. Because fewer individuals are now employed, this can have an impact on an economy’s overall production.
- Economists believed that if prices rose at a set rate, workers could be deceived into accepting lower real pay (but higher nominal earnings), guaranteeing that employees were employed and the economy continued to run at full capacity.
How does Stagflation arise?
Oil Costs
- The Organization of Petroleum Exporting Countries (OPEC) imposed an embargo on Western countries in October 1973. This led the worldwide price of oil to skyrocket, raising the cost of commodities and leading to an increase in unemployment.
- Critics of this idea point out that rapid oil price shocks like that of the 1970s did not occur in conjunction with any of the subsequent times of inflation and recession.
Ineffective Economic Policies
- Another view holds that the combination of stagnation and inflation is the outcome of weak economic policy. Stagflation may be caused by harsh control of markets, products, and labour in an otherwise inflationary environment.
Gold as a Standard
- Other hypotheses suggest that monetary variables may also contribute to stagflation.
Inflation vs. Stagflation:
- Proponents of monetary theories for stagflation refer to the collapse of the gold standard as well as the historical record of long periods of concurrently declining prices and low unemployment under robust commodity-backed currency regimes.
- This would imply that, under an unbacked fiat monetary system in existence since the 1970s, inflation should be expected to endure during periods of economic stagnation, as has been the case.
- According to these views, people simply adapt their economic behaviour in response to or in anticipation of monetary policy changes. As a result, in reaction to expansionary monetary policy, prices rise across the economy without a commensurate drop in unemployment, and unemployment rates might rise or fall depending on actual economic shocks to the economy. This indicates that efforts to boost the economy during recessions may just increase prices while doing nothing to promote genuine economic development.
Inflation may be classified into two types: Cost Push and Demand Pull:
- Cost push inflation occurs when the cost of production elements such as labour and materials rise sharply, resulting in a higher cost of production. Any attempt to pass on such increasing costs to customers results in “cost push inflation,” which might, in extreme cases, lead to “demand destruction.
Controlling stagflation in the Indian economy requires the following steps:
- Reduced income and corporation taxes are the greatest policy measures because they lower labour costs and increase labour demand.
- Similarly, GST should be cut in order to minimise price increases.
- The federal government should authorise more grants-in-aid to state and municipal governments to encourage them to minimise state and local sales.
- Salary control: To restrict wage increases, a wage control strategy with government intervention should be implemented. Limiting salary rises can assist to interrupt the cycle of wage inflation and boost the economy.
- Supply-side reforms, like as privatisation and deregulation, can help to boost aggregate supply and cut production costs, which can help to alleviate stagflation. Through tax policies, the private sector must be encouraged to invest more and boost supply.
- Monetary policy: Inflation should be the key macroeconomic goal. In the short term, lowering inflation may result in increased unemployment and slower economic development. However, once the price level is under control, this unemployment may be targeted.
- Labour reforms: Labour market frictions should be decreased by lowering the time and cost required in receiving information about job prospects. Barriers that hinder access into a profession or keep wages artificially high should be abolished.
Scenario in India:
- The RBI aims for a retail inflation rate of 4%.
- The RBI wants inflation to be within a 2% range below and above the target rate (4 per cent).
- As a result, the Reserve Bank of India’s “comfort zone” for retail inflation is between 2% and 6%.”
- What is happening in India right now is known as “cost push inflation.” This indicates that rising raw material and commodity prices cause inflation. As a result, the cost of completed products manufacture, shipping, storage, and all other economic activities rise, resulting in inflation.
- This indicates that while demand for products and services has remained constant, the price at which it may be satisfied has risen.
