What are the Causes of Stagflation and their Impacts?

Stagflation is the stagnation in the growth of an economy which decreases the Gross Domestic Product (GDP) and reduces consumers' purchasing power. It can significantly reduce economic growth by increasing inflation rates and unemployment simultaneously.

Here is an insight into the leading causes of stagflation and its significant economic impact.

The scenario of stagflation was once considered impossible by economists. Although there still needs to be a genuine consensus among them about precisely what causes stagflation, they have put forward specific arguments regarding why it happens.

In general, stagflation occurs due to a supply shock which is often the result of an unexpected event. A supply shock lowers the capacity of an economy to make goods and services at given prices.

Here are 6 essential factors that are responsible for causing stagflation:

• Increase in Inflation: When the prices of raw materials increase and supply reduce, it causes the prices of various commodities and services to go up. This phenomenon is known as inflation. With the reduction in supply, there is an overall decrease in output in an economy. This also increases unemployment and is a significant cause leading to stagflation.
• Oil Price Volatility: During supply-side shocks, the prices of commodities such as oil increase worldwide. The rise in oil prices impacts the cost of almost every other good and service. As a result, businesses try to pass on extra costs to consumers by increasing prices. They also try to cut losses by lowering employees' wages and in the form of layoffs. In these scenarios, oil price shock is a fundamental cause of stagflation since it increases unemployment and underemployment, increases prices and stagnates the output in an economy.
• Unemployment and Underemployment: As a result of underemployment and layoffs, the buying capacity of individuals decreases with the decrease in income. This also forces households to refrain from purchasing many non-essential goods and services. As a result of lower income, the consumption capacity of individuals decreases. This ultimately results in slowing economic growth and makes way for even more inflation. The inability of the manufacturing sector to boost production is another main reason behind an increase in unemployment which is a leading cause of stagflation.
• Poor Economic Policies: A theory about stagflation states that it results from poorly made fiscal policies. Examples include governments imposing harsh regulations on markets, goods and labour, increasing taxes on small businesses etc. Furthermore, increased government spending is also a consequence of disastrous policy framing. In addition, stagflation can also occur due to a wage-price spiral where prices and wages rise, but the work output remains flat. In these scenarios, employers agree to the higher salary demands of workers without insisting on higher work output. Moreover, they try to put an extra cost burden on the consumers, increasing the costs of goods and services and increased wage demands.
• Differential Accumulation: This theory, like the supply shock theory, argues that there is a relation between mergers and acquisitions, globalisation and stagflation. It states that differential accumulation, which drives mergers and acquisitions, can limit the supply of goods. Moreover, it puts the capital accumulated through the process into the hands of a few people. This may increase the chances of stagnation of the economy.
• Decrease in Availability of Credit: When there is less money in circulation due to economic disasters, it reduces investment. Since suitable investments are profit sources, economic growth slows down in their absence. The unavailability of credit is also the reason for reduced industrial activity, resulting in employment opportunities needed to improve. This ultimately impacts economic growth negatively and contributes towards stagflation.

Now that you know what causes stagflation, look at how the process affects the different aspects of an economy.

It goes without saying that stagflation is terrible for the economy. This is especially true since it combines two conflicting scenarios of increasing costs and decreasing economic output.

Here are the various impacts of stagflation on an economy and consumers:

• High chances of inflation, which is a product of stagflation, are extremely harmful to the economy's overall health since the uncertainty regarding prices distorts investment decisions.
• It creates difficulties for policymakers since the policies that can improve economic output worsen inflation and vice versa.
• The trifecta of high unemployment/ underemployment, stunted economic growth, and fast-rising inflation puts considerable pressure on the economy.
• The effects of stagflation on the fixed-income markets since increasing interest rates lower bond prices and decreases equity valuations.
• Stagflation puts pressure on the citizens in an economy since it reduces their salaries, declines the value of their savings and lowers their buying capacity.
• Due to stagflation, people need to spend a significant portion of their low earnings on food, medicines and other essential consumer products.
• Since people stop spending money on non-essential commodities and services due to price hikes and other related reasons, corporate revenue declines. This is why stagflation has a detrimental effect on the economy.

Although the impacts of stagflation on an economy and consumers can be devastating, there are a few key features that can help people to identify its occurrence. Early detection will create better chances of its prevention.

The most apparent signs of stagflation are usually macroeconomic and there are 5 things that indicate its presence:

• A sudden spike in oil prices
• Global supply-chain disruptions
• A decline in economic growth
• Increasing costs of services and commodities
• A rise in the unemployment rate

Those, as mentioned above, are the tell-tale signs that are indicative of stagflation. All the adverse effects of stagflation may cause you to wonder whether there is a way to solve this problem. Read on to learn what steps can solve this problem.

Although there is no definitive cure for stagflation, specific measures can help prevent it from occurring. Here are the following 5 solutions:

• Supply-Side Solutions: Making supply-side policies like privatisation and deregulation to lower production costs, boost efficiency, and increase aggregate supply is a solution for stagflation. The government can create policies that provide tax incentives to the private sector to encourage them to spend more.
• Tax Reforms: Since the reduction in income and corporate taxes lower labour costs and increase demand, these are the best policy measures. For example, taxes like GST in India can be cut to keep the price growth in check.
• Monetary Policies: Reducing inflation rates should be the foremost macroeconomic goal for any economy. This may result in slow growth of the economy and increase unemployment rates in the short term. However, once the prices are controlled, the government can frame policies to check the unemployment problem.
• Pay Control: The government can implement a proper wage control strategy to limit excessive wage increases. This is because it forces businesses to reduce production and employment when wages increase. Moreover, restricting salary rises will strengthen economic growth by breaking the cycle of wage inflation.
• Labour Market Reforms: The government can reduce friction in the job market by reducing the time and effort of acquiring job-related information. They can also reduce barriers to entering professions and other factors that cause an artificial increase in wages.

Stagflation is highly detrimental to an economy since it negatively impacts the overall economic scenario. However, if central banks and governments know the causes of stagflation and its signs, they can take corrective measures to check it at its root. Tackling supply-side issues and controlling food prices will help the government efficiently handle stagflation in the economy.