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Stagflation, a portmanteau of the words stagnation and inflation, is a term in macroeconomics used to describe a period of high price inflation combined with slow output growth, high unemployment, or recession. The term Stagflation was first used by Dr Peter Beter, ex-general counsel for the Export-Import Bank of the United States--Originally incorporated as the Export-Import Bank of Washington in 1934. "Stag" refers to a sluggish economy, while "flation" signifies rapidly rising consumer prices.

Stagflation is a problem because most tools for directing the economy, that is fiscal policy and monetary policy can trade off growth for inflation. Either they slow growth to reduce inflationary pressures, or they allow general increases in price to occur while generating output growth. Stagflation creates a policy bind in which efforts to correct one problem can worsen the other. The dilemma in monetary policy is instructive. The central bank can make one of two choices, each with negative outcomes. First, the bank can choose to stimulate the economy and create jobs by increasing the money supply (by purchasing government debt), but this risks boosting the pace of inflation. The other choice is to pursue a tight monetary policy (reducting government debt purchases in order to raise interest rates) to reduce inflation, at the risk of higher unemployment and slower output growth.

The problem for fiscal policy is far less clear. Both revenues and expenditures tend to rise with inflation, all else equal, while they fall as growth slows. Unless there is a differential impact on either revenues or spending due to stagflation, the impact of stagflation on the budget balance is not altogether clear. As a policy matter, there is one school of thought that the best policy mix is one in which government stimulates growth through increased spending or reduced taxes while the central bank fights inflation through higher interest rates. In reality coordinating fiscal and monetary policy is not an easy task.

Contents 1 Theories of stagflation 1.1 Neo-classical theory 1.2 Shock theory 1.3 Quality of money theories 1.4 Quantity theories of stagflation 1.5 Classical Keynesianism and the Phillips curve 1.6 Neo-Keynesianism 2 Historical stagflation 2.1 Stagflation in the late Classical Keynesian Period (1968-1982) 2.2 Stagflation worries in the present 3 Responses to stagflation

In neo-classical economic theory, stagflation is rooted in the failure of the overall market to allocate goods and services efficiently. The root cause of this is generally thought to be excessive government regulation. In this view the solution is adjustment - use monetary policy to crush inflationary pressures, and deregulate to force economic activity to more effectively reflect supply and demand. The monetary leg of this "disinflationary" neo-classical policy was pursued in the USA by Paul Volcker starting in 1979, and late in the Carter Administration. Some elements of this policy were maintained in the Reagan Administration. Neo-classical theory also prescribes increasing consumption taxes, in order to encourage saving over spending.

One set of theories argue that stagflation occurs because of outside forces to an economy or "exogenous" factors. In this view stagflation is thought to occur when there is an adverse shock (a sudden increase, for example in the price of oil), in a country's aggregate supply curve.

Modern monetary economics assumes that a crucial role for central banks in maintaining stable prices is management of inflationary expectations. If central banks are seen to pursue growth at the cost of higher inflation, economic factors may conclude that the central bank will continue to allow high inflation, and so demand higher prices for their products and higher wages for their labor. Inflation can thus become imbedded through self-fulfilling inflationary expectations. One school of thought is that inflation targeting and other forms of limited central bank discretion are the best way to maintain low inflationary expectations. The Federal Reserve in the US has, however, managed to drive inflationary expectations to a quite low level while maintaining broad policy discretion. These theories are often combined with "quantity" theories of money supply, though not always.

Quantity theories of inflation, such as monetarism, argue that inflation is due to the money supply rather than demand and predict that inflation can occur with high unemployment if the government increases the money supply in a period of rising prices.

In the 1960s it was thought that the Phillips curve, which was associated with Keynesian economics suggested that stagflation is impossible because high unemployment lowers demand for goods and services which lowers prices. This results in low or no inflation. However, in the 1970s and 1980s, when actual stagflation occurred, it was realized that the relationship between inflation and employment levels was not a constant, but could be shifted, and that the Phillips relationship was better seen through payroll surveys (Current Employment Statistics) of employment rather than household surveys (Current Population Survey) ([1]).

Neo-Keynesian theory developed a more detailed model of inflation which argued that there are two kinds of inflation - wage pull and cost push. Stagflation, in this view, is caused by cost push inflation, which could be the result of monetary policy, insufficient resiliency of the economy or from purely external factors. In this case the strategy for defeating stagflation is to cut the money supply, hoping to cut inflation to manageable levels, then increase the money supply to spur economic growth. This "disinflationary" Neo-Keynesian policy was pursued in the USA by Paul Volcker during the Carter Administration.

Stagflation occurred in the economies of the United Kingdom in the 1960s and 1970s and the United States during the 1970s, most famously during the Carter Administration. The difficulty in fitting its existence within a Keynesian framework led to a greater acceptance of monetarist theories in the 1970s and 1980s. The pendulum has, to some extent, swung back in the other direction as monetarism has seemed to encounter increasing difficulty predicting the demand for money and the long period of low inflation and high employment during the Y2K/dotcom bubble of the late 1990s and again during the 2004-2006 period, which temporarily drove oil prices high enough to measureably increase inflation during the first three quarters of 2006.

The monetarists would respond that inflation was remarkably stable during the dotcom boom and recession and that the oil price driven inflation was nothing more than the natural increase in price of one commodity rather than true inflation. The rise in oil prices was just that, a rise in oil prices. It had nothing to do with the value of the overall currency even if consumers lost effective currency as a result. The elimination of oil as a commodity would eliminate this "inflation".

During 2006, certain economists believed that global stagflation might return when the price of oil was close to $80 a barrel, and the US Federal Reserve was increasing interest rates. Blogs promoting fears of stagflation began getting attention even before statements by Stephen Roach and Paul Krugman. They cite a cooling housing market combined with a failure to adjust monetary policy as potentially leading to higher than "comfort zone" inflation and slower growth.

Stagflation undermined the dominant Keynesian consensus, and placed renewed emphasis on microeconomic behavior, particularly neo-classical economics with its attempt to root macroeconomics in microeconomic formalisms. The rise of conservative theories of economics, including monetarism, can be traced to the failure, or perceived failure, of Keynesian policies to combat stagflation, or even properly explain it. Conversely, Keynesian theory was altered, and the resulting school of thought termed Neo-Keynesian.

Stagflation in the USA was defeated by the then Federal Reserve chairman, Paul Volcker, who sharply increased interest rates to reduce money supply from 1979-1983 in what was called a "disinflationary scenario." Starting in 1983, fiscal stimulus and money supply growth combined to create a sharp economic recovery which is in line with standard macro-economic models.

Supply-side economics emerged as a response to US stagflation in the 1970s. It largely attributed inflation to the ending of the Bretton Woods system in 1971 and the lack of a specific price reference in the subsequent monetary policies (Keynesian and Monetarism). Supply-side economics asserts that the contraction component of stagflation resulted from an inflation-induced rise in real tax rates (see bracket creep). In addition certain states in the USA had laws limiting nominal interest rates, which under high inflation resulted in negative real interest rates. In some places this caused a collapse in lending to business.

The coinage of the term "stagflation" has been claimed for UK Chancellor of the Exchequer Iain Macleod.