Economists offer two principal explanations for why stagflation occurs. First, stagflation can result when an economy is slowed by an unfavorable supply shock, such as an increase in the price of oil in an oil importing country, which tends to raise prices at the same time that it slows the economy by making production less profitable. This type of stagflation presents a policy dilemma because most actions to assist with fighting inflation worsen economic stagnation and vice versa. Second, both stagnation and inflation can result from inappropriate macroeconomic policies. For example, central banks can cause inflation by permitting excessive growth of the money supply, and the government can cause stagnation by excessive regulation of goods markets and labor markets; together, these factors can cause stagflation. Both types of explanations are offered in analyses of the global stagflation of the 1970s: it began with a huge rise in oil prices, but then continued as central banks used excessively stimulative monetary policy to counteract the resulting recession, causing a runaway wage-price spiral.
John Maynard Keynes wrote in The Economic Consequences of the Peace that governments printing money and using price controls were causing a combination of inflation and economic stagnation in Europe after World War I. Stagflation was also a very serious macroeconomic problem in the 1970s. In contrast to central bank responses to the oil price spike of the 1970s where similar policies were pursued on both sides of the Atlantic, the 21st century began with America going one way to fight recession and Europe going the other way to fight inflation.
The explanation for the shift of the Phillips curve was initially provided by the monetarist economist Milton Friedman, and also by Edmund Phelps. Both argued that when workers and firms begin to expect more inflation, the Phillips curve shifts up (meaning that more inflation occurs at any given level of unemployment). In particular, they suggested that if inflation lasted for several years, workers and firms would start to take it into account during wage negotiations, causing workers' wages and firms' costs to rise more quickly, thus further increasing inflation. While this idea was a severe criticism of early Keynesian theories, it was gradually accepted by the Neo-Keynesians.
Contemporary Keynesian analyses argue that stagflation can be understood by distinguishing factors that affect aggregate demand from those that affect aggregate supply. While monetary and fiscal policy can be used to stabilize the economy in the face of aggregate demand fluctuations, they are not very useful in confronting aggregate supply fluctuations. In particular, an adverse shock to aggregate supply, such as an increase in oil prices, can give rise to stagflation.
Neo-Keynesian theory distinguished two distinct kinds of inflation: demand-pull (caused by shifts of the aggregate demand curve) and cost-push (caused by shifts of the aggregate supply curve). Stagflation, in this view, is caused by cost-push inflation. Cost-push inflation occurs when some force or condition increases the costs of production. This could be caused by government policies (such as taxes), or from purely external factors such as a shortage of natural resources or an act of war.
In the resource scarcity scenario (Zinam 1982), stagflation results when economic growth is inhibited by a restricted supply of raw materials. That is, when the actual or relative supply of basic materials (fossil fuels (energy), minerals, agricultural land in production, timber, etc.) decreases and/or cannot be increased fast enough in response to rising or continuing demand. The resource shortage may be a real physical shortage or a relative scarcity due to factors such as taxes or bad monetary policy which have affected the "cost" or availability of raw materials. This is consistent with the cost-push inflation factors in neo-Keynesian theory (above). The way this plays out is that after supply shock occurs, the economy will first try to maintain momentum — that is, consumers and businesses will begin paying higher prices in order to maintain their level of demand. The central bank may exacerbate this by increasing the money supply, by lowering interest rates for example, in an effort to combat a recession. The increased money supply props up the demand for goods and services, though demand would normally drop during a recession.
In the Keynesian model, higher prices will prompt increases in the supply of goods and services. However, during a supply shock (i.e. scarcity, "bottleneck" in resources, etc.), supplies don't respond as they normally would to these price pressures. So, inflation jumps and output drops, producing stagflation.
Under this set of theories, the solution to stagflation is to restore the supply of materials. In the case of a physical scarcity, stagflation is mitigated either by finding a replacement for the missing resources or by developing ways to increase economic productivity and energy efficiency so that more output is produced with less input. For example, in the late 1970s and early 1980s, the scarcity of oil was relieved by increases in both energy efficiency and global oil production. This factor, along with adjustments in monetary policies, helped end stagflation.
If the resource scarcity is being caused by flawed market intervention (e.g., bad government), the solution is to eliminate the disrupting force on the market (e.g., better monetary policy, changes in tax laws).
A purely neoclassical view of the macroeconomy rejects the idea that monetary policy can have real effects. Neoclassical macroeconomists argue that real economic quantities, like real output, employment, and unemployment, are determined by real factors only. Nominal factors like changes in the money supply only affect nominal variables like inflation. The neoclassical idea that nominal factors cannot have real effects is often called 'monetary neutrality' or also the 'classical dichotomy'.
Since the neoclassical viewpoint says that real phenomena like unemployment are essentially unrelated to nominal phenomena like inflation, a neoclassical economist would offer two separate explanations for 'stagnation' and 'inflation'. Neoclassical explanations of stagnation (low growth and high unemployment) include inefficient government regulations or high benefits for the unemployed that give people less incentive to look for jobs. Another neoclassical explanation of stagnation is given by real business cycle theory, in which any decrease in labour productivity makes it efficient to work less. The main neoclassical explanation of inflation is very simple: it happens when the monetary authorities increase the money supply too much.
In the neoclassical viewpoint, the real factors that determine output and unemployment affect the aggregate supply curve only. The nominal factors that determine inflation affect the aggregate demand curve only. When some adverse changes in real factors are shifting the aggregate supply curve left at the same time that unwise monetary policies are shifting the aggregate demand curve right, the result is stagflation.
Thus the main explanation for stagflation under a classical view of the economy is simply policy errors that affect both inflation and the labor market. Ironically, a very clear argument in favor of the classical explanation of stagflation was provided by Keynes himself. In 1919, John Maynard Keynes described the inflation and economic stagnation gripping Europe in his book The Economic Consequences of the Peace. Keynes wrote:
Keynes explicitly pointed out the relationship between governments printing money and inflation.
Keynes also pointed out how government price controls discourage production.
Keynes detailed the relationship between German government deficits and inflation.
While most economists believe that changes in money supply can have some real effects in the short run, neoclassical and neokeynesian economists tend to agree that there are no long run effects from changing the money supply. Therefore, even economists who consider themselves neokeynesians usually believe that in the long run, money is neutral. In other words, while 'neoclassical' and 'neokeynesian' models are often seen as competing points of view, they can also be seen as two descriptions appropriate for different time horizons. Many mainstream textbooks today treat the neokeynesian model as a more appropriate description of the economy in the short run, when prices are 'sticky', and treat the neoclassical model as a more appropriate description of the economy in the long run, when prices have sufficient time to adjust fully.
Therefore, while mainstream economists today might often attribute short periods of stagflation (not more than a few years) to adverse changes in supply, they would not accept this as an explanation of very prolonged stagflation. More prolonged stagflation would be explained as the effect of inappropriate government policies: excessive regulation of product markets and labor markets leading to long run stagnation, and excessive growth of the money supply leading to long run inflation.
An important monetary mechanism to increase economic growth is by lowering interest rates, which reduces the cost for consumers to buy products on credit and businesses to borrow to expand production. While this can increase economic activity, it can also result in increased inflation. The monetary mechanism to reduce inflation is by raising interest rates, which increases the cost for consumers to buy products on credit and businesses to borrow to expand production. While this can reduce inflation, it can also result in decreased economic activity.
Stagflation becomes a problem only when the impact of the further use of the principal monetary policy tool available to assist central bank direction of the domestic economy does more marginal harm than marginal good, if used. Ultimately, the central bank can either stimulate the economy or attempt to rein it in through the mechanism of adjusting the domestic interest rate, its primary tool.
A choice can be implemented that tends to improve growth, but does it ignite systemic inflation? A choice can be implemented that tends to fight inflation, but how badly does it impinge growth? During periods properly described as stagflation both problems co-exist. In modern times, it will be only after the central bank has used all possible tools to meet both goals, using the best quantitative measures it has at its disposal, for stagflation to occur. Major economic conditions of unusual proportion will have already created near-crises on both fronts before stagflation can set in again. Stagflation is the name of the dilemma that exists when the central bank has rendered itself powerless to fix either inflation or stagnation.
The problem for fiscal policy is far less clear. Both revenues and expenditures tend to rise with inflation, and with balanced budget politics, 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. One school of thought is 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. Whatever theory is employed, coordinating fiscal and monetary policy is not an easy task.
Federal Reserve chairman Paul Volcker very sharply increased interest rates from 1979-1983 in what was called a "disinflationary scenario." After U.S. prime interest rates had soared into the double-digits, inflation did come down. Volcker is often credited with having stopped at least the inflationary side of stagflation, although the American economy also dipped into recession. Starting in approximately 1983, growth began a recovery. Both fiscal stimulus and money supply growth were policy at this time. A five-to-six-year jump in unemployment during the Volcker disinflation suggests Volcker may have trusted unemployment to self-correct and return to its natural rate within a reasonable period.
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 economists asserted that the contraction component of stagflation resulted from an inflation-induced rise in real tax rates (see bracket creep)
At around the same time, commodity prices soared resulting in, for example, a one-year gain in the price of oil from about $70 per barrel to about $145 per barrel at the July, 2008 peak, depending on market and grade. Agricultural commodities, many base metals, precious metals and most major currencies also appreciated significantly against the U.S. dollar during or before this rise in the price of oil, even provoking some government and inter-governmental agency action in currency and commodity markets.
Economic growth slowed as watchers saw hope fade that a "post-Credit-Crisis period" had dawned, resulting in a recognition that recession had begun in the developed economies. The major developed economies almost universally reacted by "printing money"; in the United States alone, permanent funding approaches a total of one trillion dollars and temporary funding is nearly double that much. In parallel the central bank is seen as certain to lower interest rates to a further non-economic low, which will drive down the dollar and drive up commodity prices. These are classic causes of inflation during recesion, i.e., stagflation.
However, in tandem with or somewhat before the July, 2008 peak price in oil, most major exchange-traded commodities began to fall rapidly in price, suggesting to yet other economists and commentators that a trend of deflation - rather than inflation or stagflation - might obtain.