Stagflation is the combination of high inflation, stagnant economic growth, and elevated unemployment. The term stagflation, a portmanteau of "stagnation" and "inflation", was popularized and probably coined by British politician Iain Macleod in the 1960s, during a period of economic distress in the United Kingdom. It gained broader recognition in the 1970s after a series of global economic shocks, such as the closure of the Suez Canal (1967–1975) and the 1973 oil crisis, which disrupted supply chains and led to rising prices and slowing growth. Stagflation challenges traditional economic theories, which suggest that inflation and unemployment are inversely related, as depicted by the Phillips Curve. Stagflation presents a policy dilemma, as measures to curb inflation—such as tightening monetary policy—can exacerbate unemployment, while policies aimed at reducing unemployment may fuel inflation. In economic theory, there are two main explanations for stagflation: supply shocks, such as a sharp increase in oil prices, and misguided government policies that hinder industrial output while expanding the money supply too rapidly. The stagflation of the 1970s led to a reevaluation of Keynesian economic policies and contributed to the rise of alternative economic theories, including monetarism and supply-side economics.
Etymology The term, a portmanteau of stagnation and inflation, is generally attributed to Iain Macleod, a British Conservative Party politician who became Chancellor of the Exchequer in 1970. Macleod used the word in a 1965 speech to Parliament during a period of simultaneously high inflation and unemployment in the United Kingdom. Warning the House of Commons of the gravity of the situation, he said:
We now have the worst of both worlds—not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of "stagflation" situation. And history, in modern terms, is indeed being made. Macleod used the term again on 7 July 1970, and the media began also to use it, for example in The Economist on 15 August 1970, and Newsweek on 19 March 1973. John Maynard Keynes did not use the term, but some of his work refers to the conditions that most would recognise as stagflation.
1976 Sterling crisis
The United Kingdom experienced an outbreak of inflation in the 1960s and 1970s. As inflation rose, British policy makers failed to recognise the primary role of monetary policy in controlling inflation. They tried to use non-monetary policies and devices to respond to the economic crisis. Policy makers also made "inaccurate estimates of the degree of excess demand in the economy, [which] contributed significantly to the outbreak of inflation in the United Kingdom in the 1960s and 1970s." Stagflation was not limited to the United Kingdom. Economists have shown that stagflation was prevalent among seven major market economies from 1973 to 1982. After inflation rates began to fall in 1982, economists' focus shifted from the causes of stagflation to the "determinants of productivity growth and the effects of real wages on the demand for labor".
Causes
Economists offer two principal explanations for why stagflation occurs. First, stagflation can result when the economy faces a supply shock, such as a rapid increase in the price of oil. An unfavourable situation like that tends to raise prices at the same time as it slows economic growth by making production more costly and less profitable. Second, the government can cause stagflation if it creates policies that harm industry while growing the money supply too quickly. These two things would probably have to occur together because policies that slow economic growth rarely cause inflation, and policies that cause inflation rarely slow economic growth.
Supply shock
As soon as the Six-Day War started in 1967 and Israel invaded the Sinai Peninsula down to the Suez Canal, the Egyptian President Gamal Abdel Nasser, who was aligning with the Soviet Union, closed down the Suez Canal for eight years. Oil from the Middle East to Europe had to be rerouted around Africa. Egypt then tried to cross the Suez Canal and take back the Sinai Peninsula in the Yom Kippur War in late 1973. Richard Nixon supported funding Israel with $2.2 billion over the conflict, which triggered an oil embargo in October 1973 when the countries of the Organization of Arab Petroleum Exporting Countries (OAPEC) cut production of oil and placed an embargo on oil exports to the United States and other countries backing Israel.
Excess demand
Money supply in the early 1970s increased at almost 15% year over year in the United States and the Consumer price index lags behind about one year or two. Britain's monetary policy was also dovish causing excess demand.
End of Bretton Woods system
In the mid 1970s, the Bretton Woods system was failing. The fixed exchange rate between countries' currencies started to float, and the gold standard, under which currencies were pegged to gold, was abandoned. After many years of stability, the price of gold and oil became very volatile.
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