Effects of Inflation on Economic Growth:Here we would not discuss all extreme high and low cases of Inflation. We would talk about consequences of controlled positive inflation that is targeted by central Bank (RBI). Inflation is sustainable increase in Consumer Price Index (Price of products and services) over time. In general, inflation and economic growth of nation follows each other. Positive inflation from 2% to 6% of inflation is considered a good level of Inflation. Although, targeted level of inflation varies with respect to economic condition of each country.
Talking about Inflation and Unemployment, optimum Inflation brings the unemployment numbers down. How? As we discussed above, inflation comes with economic growth, economic growth will lead to increased wages and earnings. People with more money will engage in spending activities more and due this increased demand, production increases which automatically requires large labor force and workers. This theory was suggested by Mr. AW Phillips from UK with help of a curve called Phillips curve.
Phillips Curve, as you can see above, suggest that there is somewhat inverse relation between Inflation and Unemployment. If inflation increases, then it brings unemployment rates down. Vice-versa is also applicable. We are not saying that everyone gets benefit from the inflation, we are just discussing the effects of inflation on unemployment and economic growth so that, you can understand the concept of stagflation better.
What is Stagflation?Stagflation is a condition where inflation is significantly prevalent but there is decrease in real output. By output, I mean production and economic growth. In other words, we can say that inflation is persistent but instead of growth, the economy is facing a slowdown, decreasing production and increasing unemployment rates.
This is contradictory to what we discussed under above heading. During 1960s, almost all nations had started to believe the theory put forward by Mr. AW Phillips and is Phillips Curve. But when USA faced both i.e. high unemployment rates and highly increasing inflation rate, it gave a topic to economists all over the world to do more research.
How Bad is Stagflation?Stagflation is one of the worst conditions that an economy can face. It is very rare to observe stagflation as both government and Central Banks always try to prevent this from happening. But if once any country is attacked by both flood (economic slowdown which drains the production activities from nation) and fire (inflation burning people’s money), it is a worst condition. To understand this, you just simply need to imagine a condition where your income is decreasing over time but prices of products keep increasing. In such condition, you will have to make compromise with your savings or daily usage. I f a country faces higher or lower inflation than their targeted levels, it is comparatively easier for it control by pulling their economic levers (using all methods possible) but if both inflation and unemployment are increasing (as in stagflation), it is way more difficult to control. For an instance, assume that a country tries to increase spending to control unemployment. This can control unemployment but this might provide more up thrust to the prevalent inflation because this is what Phillips curve suggests (increasing inflation leads to decrease in unemployment rate while decrease in inflation can increase unemployment rate). So, it really is a tough scenario where controlling one factor can provide a boost to the other.
Stagflation is a condition when productions would be decreasing, labour would move out of the economic system (due to less production) gradually to increase unemployment rate. It is a condition when both demand and supply decrease but then also, prices keep increasing. So how does Stagflation happen? What are the factors that cause Stagflation? Let us dig in.
What is Stagflation caused by?Stagflation occurs when economy is going through a slowdown or recession but cost-pull factors (like increase in the price of Raw material) become active and leads to increasing prices. You will understand it by having a look on the stagflation in USA in 1970s.
US economy was already facing economic challenges during 1970s due the huge spending on Vietnam war. But after that, oil producing countries suddenly increased the oil prices by huge rate which put further pressure on US economy. As oil increased the cost of production (running machinery also require energy) and cost of transportation, it led to huge amount of inflation. This caused a major disturbance in US economy and worldwide. Major factors that can contribute to the happening of Stagflation are:
1. Supply Side Shock: Supply side shock are the events that cause unexpected disruption or increase in cost of production. If cost of production increase, prices to be paid by the end users also increase. As discussed in USA’s case, increase in oil prices was major factor behind increasing prices at high rate. Indian economy also depends on coal, natural gas, Petroleum and uranium for energy. If price of such raw material increases suddenly by large amount, they have potential to increase the prices even during the period of recession or economic slowdown.
2. Falling Productivity: Fall in productivity can be due to any reason like inefficient labor etc. but this increases the cost of production which leads to increase in prices.
3. Rise in Structural unemployment: Structural Unemployment is an involuntary type of unemployment which occurs when there is a mismatch between the skills of job seekers and the skills required for the jobs available. It means, even though you have a skill, you cannot get job because jobs requiring your skill are not vacant or available. For example, due to sudden boost in artificial intelligence, many human labor jobs can be displaced and most of the Labourers in India are not skilled enough to provide some professional skill, they may leave with part-time or disguised unemployment. If unemployment conditions rise during high inflation periods, it can constitute to Stagflation.
Factors discussed above are only major ones and they also can not lead to stagflation on their own. Stagflation is observed when multiple factors get wrong for the economy. So how do economies prevent themselves from Stagflation? Here we will discuss about what are the measures that economies take to prevent themselves from stagflation and if they get caught by this, what they do or have done when faced it in the past?
How to Prevent and Control Stagflation?Preventing stagflation from happening means steady growth of economy with a proper control on Inflation through Monetary and Fiscal policies. We cannot clearly state what is the best way to prevent stagflation? But one thing that everyone approves is to control inflation.
Government and Reserve Bank (Central Bank of India) try to increase the short-term interest rates via controlling Repo and Reverse Repo Rates and make the creditors to tighten the credit system whenever the inflation rises too high.
If we want to prevent stagflation, we need to work on the factors and causes that make it happen. This means, government should prevent the unreasonable increase in price of raw materials, not let the wave of extreme fear pass through people, government spending’s should be carried out wisely, should have deep economic and diplomatic ties with the oil producing nation etc. According to an argument made by Economist Milton Friedman, fighting inflation is the only way to fight Inflation as fighting the other face i.e. unemployment can help only for short-term but in long run, it will further increase inflation.