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Definition:  Stagflation is the economic phenomenon in which unemployment increases along with rising inflation causing demand to remain stagnant in a given period. In fact, it is an indication of an inefficient market, as traditionally, there is an inverse relationship between unemployment rates and inflationary pressures.

What Does Stagflation Mean?

What is the definition of stagflation?  Usually, inflationary pressures are observed in economies with high growth rates, which increase the  demand  for products, and consequently,  supply . The high economic growth creates more jobs, thus compressing unemployment down.

During stagflation, unemployment and  inflation  rise together either as a result of a poor economic policy and regulations or due to an abrupt increase in the price of oil, which lowers the entire output of an economy.

Let’s look at an example.

Example

The U.S. government announces its decision to lower the  supply of money  in the economy. In the short-term, consumer spending will decrease as people will have a lower disposable income. In the long-term, the general price level will decline as consumers will be spending even less, thus lowering the profits of firms. However, the new level of prices is not immediately adjusted to the  government policy . It might take a few years until the firms issue their new price lists, and the unions are convinced to accept the new status quo.

Until the prices are adjusted to the new level, the costs will be lower, but the prices will remain persistently high, thus lowering the supply of goods and services offered by the firms. Lower supply is leading to lower production and lower sales, thus minimizing the profits of firms. Firms are forced to lay off workers and unemployment increases until the new prices fully adjust to the new price level. This is a stagflation period during which unemployment rises along with inflation.

To anticipate stagflation, the U.S. government needs to implement an economic policy that would take advantage of the inverse relationship between the unemployment and inflation. For instance, it could change the level of public spending to influence the relationship between inflation and unemployment in the short term.

Summary Definition

Define Stagflation:  Stagflation is an economic condition that causes demand to stagnate characterized by rapidly rising inflation and unemployment.


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