Stagflation

Stagflation is the term used to describe the effects of high inflation, slow economic growth and increasing unemployment. A period of stagflation would have an immediate adverse impact on consumption, production and government revenue.

Supply shocks due to natural disasters, adverse weather, war or increases in soft & hard commodity prices can slow economic growth and/or increase inflation. The below diagram illustrates how prices may increase as supply decreases.


This has a direct affect on a households consumption & investment decisions. If inflation is high, the household may choose to consume only essential items such as utilities and food. The production sector could suffer a double blow from low consumption and an increase in raw material prices. This flow will then continue to the governments income from taxes which will be reduced. There is the potential for the stagflation to spiral deeper as the government may raise taxes, the production sector increases prices to maintain profit margin and the household consumes less & less. Additionally, if production levels are low, there is likely to be a cut back on the levels of employment which furthers the likelihood of stagflation.

The monetary policy by the central banks can also be a catalyst for stagflation. A prime example of this is the FED's decision to cut interest rates during the current credit crisis. These rate cuts have a direct affect on the exchange rate of the US dollar. The value of the US dollar has decreased against other fiat currencies, such as the euro (diagram). This makes imports more expensive which again affects household consumption and the resulting flow.



Additionally, the availability of cheap credit by way of low interest rates facilitates inflation as households are more likely to increase consumption than to increase savings due to low rates. Cheap credit leads to an increase in lending which can result in households spending beyond their means or bidding up the price in consumables, hence the inflation risk.