Stagflation
What is Stagflation?
Stagflation is the simultaneous combination of stagnant growth, high unemployment, and high inflation.
It is caused by a leftward shift of short-run aggregate supply, such as a sharp rise in oil prices (a negative supply shock). It is hard for policymakers because fixing unemployment and fixing inflation call for opposite policies. The 1970s U.S. economy is the classic example.
Stagflation: a worked example
Start a hypothetical economy at full employment: price index 100, real GDP $600 billion, unemployment 5 percent. A drought triples fertilizer prices and a shipping disruption doubles freight costs, so producing any given output costs more and SRAS shifts left. The new equilibrium sits at price index 108 and real GDP $582 billion, with unemployment at 7.5 percent. Inflation is 108 minus 100, divided by 100, or 8 percent, while real GDP falls by $18 billion, a decline of 3 percent. Both bad numbers arrive together, which is stagflation. Now watch the policy trap. Shifting AD right far enough to return output to $600 billion pushes the price index to 114, worsening inflation. Shifting AD left far enough to bring the price index down to 102 drags real GDP to $564 billion and unemployment near 10 percent. Neither tool fixes both halves.
The mistake students make with stagflation
Asked to draw stagflation, students shift aggregate demand left. The choice is tempting because a leftward AD shift genuinely produces falling real GDP and rising unemployment, which covers the stagnation half. But it also drags the price level down, so it delivers deflation and contradicts the other half of the term. Only a leftward shift of short run aggregate supply raises the price level and cuts real output at the same time. A second slip attaches the label to any burst of inflation, when the term requires output falling while prices rise.
Stagflation questions
What causes stagflation?
A negative supply shock causes stagflation. Something raises the cost of producing at every price level, such as a jump in energy or raw material prices, a natural disaster that destroys capital, a sharp rise in negotiated wages, or a new regulation that lifts unit costs across industries. Short run aggregate supply shifts left, pushing the price level up while real output and employment fall. Persistent expectations of high inflation can keep the curve shifting and make the episode last.
Why is stagflation so hard for policymakers to fix?
Each half of the problem calls for the opposite policy. Expansionary spending or rate cuts push aggregate demand right, restoring output and jobs but driving the price level higher still. Contractionary policy tames inflation but deepens the output loss and raises unemployment further. No single shift of aggregate demand can undo a leftward supply shift, so the real remedies are supply side, such as lowering input costs, raising productivity, or anchoring inflation expectations, and those work slowly.
How is stagflation different from a normal recession?
A normal recession usually starts with falling aggregate demand, so real GDP and the price level move down together and inflation cools while unemployment climbs. Stagflation starts on the supply side, so real GDP falls while the price level rises, and the inflation rate and the unemployment rate both get worse at once. Graphically, a demand driven recession moves equilibrium down and to the left, while stagflation moves it up and to the left.
This is the live AD/AS Model sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
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