14.2 Stagflation and Its Causes

The 1970s saw a perfect storm of economic woes: high inflation, slow growth, and rising unemployment. This unusual combination, called stagflation, baffled economists and policymakers who were used to seeing inflation and unemployment move in opposite directions.

Oil shocks, loose monetary policy, and structural economic changes all contributed to stagflation. Businesses struggled with rising costs and unpredictable demand, while the government grappled with how to stimulate growth without worsening inflation. The era reshaped economic thinking and policy approaches.

Stagflation: Definition and Characteristics

Economic Conditions and Indicators

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• Stagflation combines "stagnation" and "inflation" describing slow economic growth, high unemployment, and rising prices
• Persistent high inflation rates typically above 5% annually coupled with stagnant or declining GDP growth
• Unusually high misery index (sum of unemployment rate and inflation rate) indicates widespread economic hardship
• Decline in productivity growth and rise in the natural rate of unemployment often accompany stagflation
• Contradicts traditional economic theories suggesting inflation and unemployment typically have an inverse relationship

Theoretical Implications

• Challenges Phillips Curve theory positing an inverse relationship between unemployment and inflation rates
• Defies conventional economic wisdom about trade-offs between inflation and unemployment
• Requires new economic models to explain simultaneous occurrence of high inflation and high unemployment
• Highlights complexities of macroeconomic relationships and limitations of existing economic theories
• Prompts reassessment of monetary and fiscal policy effectiveness in managing economic stability

Causes of 1970s Stagflation

Oil Shocks and Energy Crisis

• 1973 OPEC oil embargo dramatically increased energy prices causing a supply shock throughout the economy
• Quadrupling of oil prices from $3 to$12 per barrel between 1973 and 1974
• Second oil shock in 1979 triggered by Iranian Revolution intensified inflationary pressures and economic stagnation
• Oil prices surged from $13 to$34 per barrel between 1979 and 1981
• Energy-intensive industries (manufacturing, transportation) particularly affected leading to widespread cost increases

Monetary and Fiscal Policies

• Expansionary monetary policies by Federal Reserve in late 1960s and early 1970s contributed to inflationary pressures
• Abandonment of Bretton Woods system and gold standard in 1971 led to U.S. dollar devaluation and increased import prices
• Vietnam War and increased social spending contributed to rising government deficits putting additional pressure on the economy
• Federal budget deficit grew from $2.8 billion in 1970 to$73.7 billion in 1980
• Wage-price spirals occurred as workers demanded higher wages to keep up with inflation leading businesses to raise prices further

Structural Economic Changes

• Declining productivity growth in 1970s partly due to structural changes in the economy exacerbated stagflation
• Shift from manufacturing to service-based economy contributed to slower productivity growth
• Increased global competition particularly from Japan and Germany impacted U.S. industrial competitiveness
• Technological changes and automation began displacing workers in certain industries
• Demographic shifts with baby boomers entering workforce affected labor market dynamics and wage pressures

Business Challenges in Stagflation

Cost Pressures and Pricing Dilemmas

• Businesses struggled with rising input costs particularly energy and raw materials squeezing profit margins
• Labor costs increased as workers demanded higher wages to keep pace with inflation
• Unpredictable inflation rates made long-term planning and investment decisions challenging
• Reduced capital expenditures and slower economic growth resulted from uncertainty
• Inventory management challenges due to fluctuating prices and uncertain demand led to increased carrying costs

Financial and Operational Hurdles

• High interest rates implemented to combat inflation increased borrowing costs for businesses
• Prime rate reached a peak of 21.5% in December 1980
• Limited ability to expand or invest in new technologies due to high borrowing costs
• Consumer spending patterns became erratic as households grappled with rising prices and economic uncertainty
• Demand forecasting difficulties for businesses due to volatile consumer behavior
• International competitiveness of U.S. businesses affected by changing value of dollar and global economic instability

Government Policies vs Stagflation

Monetary and Fiscal Interventions

• Federal Reserve's stop-go monetary policy alternating between tightening and easing contributed to economic volatility
• Volcker shock implemented by Federal Reserve Chairman Paul Volcker in 1979 successfully broke inflation
• Federal funds rate raised to 20% in June 1981 to combat inflation
• Severe recession in early 1980s resulted from tight monetary policy
• Fiscal policies including targeted tax cuts and increased government spending struggled to stimulate growth without exacerbating inflation

Regulatory and Structural Reforms

• Nixon administration's wage and price controls implemented in 1971 proved largely ineffective
• Controls distorted market signals leading to shortages and economic inefficiencies
• Supply-side economic policies introduced in late 1970s and early 1980s aimed to boost productivity and growth
• Tax cuts and deregulation had mixed long-term results on economic performance
• Energy policies such as creation of Strategic Petroleum Reserve and promotion of energy conservation helped reduce U.S. vulnerability to oil shocks

Long-term Policy Outcomes

• Resolution of stagflation in mid-1980s largely attributed to combination of tight monetary policy supply-side reforms and favorable global conditions
• Inflation rate decreased from 13.5% in 1980 to 3.2% in 1983
• GDP growth rebounded from -0.3% in 1980 to 7.2% in 1984
• Long-term structural changes in economy including increased globalization and technological advancements reshaped policy approaches
• Shift towards inflation targeting and greater central bank independence emerged as lessons from stagflation era