It is generally accepted among economists that inflation, as inconvenient as it may be to most consumers, is necessary for economic growth to take place. With inflation, people spend more money knowing that it will be less valuable in the future, and so they might as well get the best bang for their buck by spending right now. This spending does 2 things: it lowers unemployment (more spending means more money for businesses, which means they are able to hire more workers) and increases the GDP in the short term (which is partly made up of consumer spending), which in turn brings about further price increases, and so on.
In other words, a little inflation of around 1% to 2% is beneficial for an economy. But this doesn’t mean an inflation rate of 8.6% will double the economic growth of a 4.3% inflation rate. There comes a point in the rate of inflation where the cons outweigh the pros, where unemployment stops decreasing and economic growth slows. This plight is called stagflation, where heightened inflation doesn’t result in the same benefits that a tamed inflation rate does.
What causes stagflation?
Most economists point to 2 key culprits for stagflation’s existence in the first place:
Supply shock: a sudden decrease in the supply of a good or service, particularly one that’s essential for a country’s supply chain. Think of things like oil - a commodity that’s extremely pervasive throughout the entire world economy, so if it were to abruptly become much less accessible, it’s going to be felt basically everywhere. Even in industries that aren’t directly involved in oil, those businesses still use items and equipment that are made out of, among other things, oil. If the price of oil goes up (as a result of the decreased supply), then as will the price of those items and thus the cost of doing business.
Government policies: in this case, a country’s economic policies would be conflicting in that some would be expansionary and others would be contractionary. For example, if policymakers decide to lower the federal funds rate (an expansionary policy) but also decide to reduce government spending (a contractionary policy), then stagflation may occur as we have policies that harm industry (the reduced fiscal expansion) and policies that increase the money supply (the lowering of the federal funds rate)
The second reason is a particularly interesting scenario, as it speaks to the problem of a country’s limits in economic output and monetary policy. When a central bank increases their country’s money supply (through the lowering of interbank lending rates), that tends to increase both prices and the national output of the economy. But the latter, unlike the former, is limited by the country’s capital that can be used for generating economic output in the first place. So if that limit is reached but the money supply continues to expand, the only thing that really can happen is for prices to continue to increase…without any economic growth to compensate for it. Hence, stagflation.
Although stagflation may appear to be this extremely intricate and tortuous phenomenon, its diagram is rather straightforward:
What’s being shown here is that price level at P1 corresponds with economic output in real GDP at Y1. But then the price level increases to P2 at the economic output in real GDP of Y2. The country’s overall output is decreasing - the aggregate supply curve is shifting to the left from AS1 to AS2, causing the point of intersection between price and output along the AD (aggregate demand) line to also shift leftwards - but the overall price level is increasing. A decreased economic output should ordinarily be followed by a decrease in price, but that doesn’t occur under stagflation; prices just keep going up.
The 70s stagflation and Paul Volcker
By far the most well-documented case of stagflation, one that you’ll find in every article explaining the phenomenon, is the stagflation the US underwent in the 1970s. In 1971, the American economy had an unemployment rate of 6.1% and an inflation rate of 5.84% - problems that President Richard Nixon wanted to address through, among other measures, the imposition of wage and price controls. He issued Executive Order 11615 which set a 90-day freeze on wages and prices in order to counter inflation.
Unfortunately, these policies resulted in a series of cost-push shocks, where prices rose due to a sudden increase in the cost of wages and raw materials - a rather common ramification of price controls. But that wasn’t all: in 1973, the Organization of Petroleum Exporting Countries (OPEC, an intergovernmental organization that exports around 60% of the world’s oil) proclaimed an embargo against several Western nations for their support for Israel in the Yom Kippur War. The result was what you’d expect - a worldwide shortage in oil and thus, a skyrocket in its price.
This all culminated in a recession which the government had originally attempted to rectify with an expansionary monetary policy, as standard procedure would have them do. But this only worsened the problem as output literally couldn’t rise any further due to the supply constraints, so all that extra money just triggered more inflation. Higher prices, reduced economic output.
And from there a seemingly never-ending cycle of economic downturn, monetary stimulus, and higher inflation ravaged the country. Then enter Fed Chairman Paul Volcker. Nominated by President Jimmy Carter 1979, Volcker did exactly the opposite of what his predecessor, G. William Miller, was doing before him - tightened monetary policy and dramatically raised interest rates.
Although unemployment sharply increased in the wake of the cost of borrowing money going up, prices eventually calmed down and Volcker has since been celebrated as the Chairman who ended American stagflation.
Econ IRL
It’s widely known that the US, like most other Western developed countries, transitioned from a manufacturing-based economy to a service-based one in the last several decades. The most commonly cited reason for this is the rise of China and American firms outsourcing their manufacturing to them. Although this is certainly a significant contributing factor, it may only be part of the picture. This week’s paper seeks to highlight the role of “intangible capital” (assets that aren’t physically real) in the growth of non-manufacturing employment.
After putting together a dataset that tracks US firms and the nature of their activities. The researchers came up with 3 key findings:
A major portion of the reallocation towards the service-based economy occurred via business services that are largely used as “input” by other firms, with firms that produce input services growing faster and pivoting more towards new industries than other firms
Surviving manufacturing firms contributed more than you’d expect to the transition, as they moved from producing physical goods and instead started serving high-skill services
The researchers develop a method to measure a firm's investments in intangible knowledge (i.e. an R&D lab) and based on this information, they find that a higher investment in intangible knowledge is correlated with higher growth and propensity to do business in emerging industries
‘Till next time,
SoBasically