Stagflation: A central banks nightmare

Stagflation is the situation marked by low economic growth and high unemployment rates accompanied by rising inflation, ie, a rise in the prices of goods and services.

The central bank of a country is tasked with designing monetary policies that help maintain lower inflation levels and steady GDP growth. It does so by controlling the money supply in the economy by way of interest rates. Interest rate (aka repo rate) changes transmit through the money market to the entire financial system, which, in turn, influences aggregate demand – a key determinant of inflation and growth. 

For instance, the increased money supply in the economy leads to higher demand for goods and services, driving their prices upwards and causing inflation. To control this situation, the central bank tightens its monetary policy and raises interest rates. This increase is passed on by commercial banks to their borrowers. This raises the cost at which consumers can borrow funds from commercial banks and deters them to borrow further. This effectively decreases the supply of money in the economy and brings down inflation. 

On the other hand, decreased money supply in the economy leads to lower demand for goods and services. This leads to a fall in economic activities, thereby slowing economic growth. To control this situation, the central bank brings down the interest rates, thereby reducing the cost of borrowing and fueling demand. Thus, this increases the supply of money in the economy and drives economic growth. 

Sounds simple, doesn’t it? But what if the economic situation is a mix of both cases? As absurd as it may sound, such a situation exists. It is known as stagflation, the abbreviated form of (economic) stagnation and inflation. Stagflation is the situation marked by low economic growth and high unemployment rates accompanied by rising inflation, ie, a rise in the prices of goods and services. 

What causes stagflation? 

At present, there are two theories on what could be the possible cause of stagflation. They are: 

A) Poor economic policies- This theory suggests poorly designed economic policies, ones that involved harsh regulation of markets, goods, and labour could be a cause of stagflation. 

B) Supply shock- As per this theory, stagflation arises when an economy experiences a sudden increase or decrease in the supply of a commodity or service (supply shock). For instance, a rapid increase in price of oil would cause a rise in the cost of production and transportation and lead to a surge in prices of goods and services. This, in turn, would lead to lower profitability, thus slowing economic growth. Such a situation arose in 1973 when the Organization of Petroleum Exporting Countries (OPEC) issued an embargo against Western countries.  

How to tackle stagflation? 

There is no defined way to tackle this situation. However, economists suggest that productivity should be increased to the point where it would lead to higher growth without additional inflation. After this, the central bank can tighten its monetary policy to rein in the inflation component of stagflation.