SUBMITTED TO Ms Tayabba SUBMITTED BY Zonaira Waseem (718) Asma Pervaiz (636) BS(HONS) IV Major Economics Section E
ASSIGNMENT QUESTIONZonaira Waseem (718) What is stagflation? What are factors causing inflation?
Asma Pervaiz (636) Briefly discuss the concept of stagflation in the current context of Pakistan.
INTRODUCTIONThe Term was First used by Lain Macleod in a speech to the British Parliament in 1965, and since then it has aptly come to describe a situation where the unemployment rate and the inflation rate are constantly rising together. This is the official definition and there really could be no easier way to define it. Stagflation describes a "perfect storm" of economic bad news: high unemployment, slow economic growth and high inflation. The term was born out of the prolonged economic slump of the 1970s when world oil prices rose dramatically, fueling sharp inflation in developed countries., For these countries, including the U.S., stagnation increased the inflationary effects. United States experienced spiking inflation in the face of a shrinking economy, something economists had previously thought to be impossible.
DEFINITION:According to Barron "STAGFLATION term was coined by economists in the 1970s to describe the unprecedented combination of slow economic growth and high unemployment (stagnation) with rising prices (inflation). In Economic Terms:
Stagflation = Stagnation + InflationAs the word stagflation is a contraction of Stagnation Inflation
Stagnation: When the economy is stagnant, it means that the gross domestic product(GDP) -- the standard measure of a nation's total economic output -- is either growing at a very slow rate or shrinking. Stagnation on the other hand results from low demand, leading low output resulting into collapse. The natural result of economic stagnation is increased unemployment. Businesses lay off employees to save money, which in turn decreases the purchasing power of consumers, which means less consumer spending and even slower economic growth.
Inflation: Inflation is the persistent rise in prices rather than a once-for-all rise inprices. Inflation is a result of high growth which increases the income and correspondingly increases the demand, thereby leading to hiking of prices. Inflation or Stagnant Economy in itself is a difficult situation for any country. This is why stagflation is so dangerous. Imagine a scenario in which you have both a sinking economy and runaway inflation. With high unemployment, consumers have less money to spend. Add inflation, and the money they do have is worth less and less every day. This is a very unhealthy situation for a country. It's a highly unusual situation because a slow economy reduces demand enough to keep prices from rising. Why? Businesses get into a competitive price war to attract whatever customers remain. Without the ability to raise prices, there usually can be no inflation.
Why STAGFLATION is so Dangerous?Economic slowdowns are a normal part of the macroeconomic cycle. When financial speculation gets out of hand (as it did with the technology stocks of the late 1990s and the housing market of the mid-2000s), the market needs to stabilize itself. This usually happens through a temporary, if painful, recession. But here's the difference between a recession and stagflation: The prolonged period of slow economic growth is coupled with high rates of inflation. Inflation is the ongoing increase in prices for goods and services, but it can also be described as an ongoing
decrease in the buying power of money. In a normal year, inflation might rise two or three percentage points. If the rate of inflation begins to rise past 5 or even 10 percent, things can get hairy. This is why stagflation is so dangerous. Imagine a scenario in which you have both a sinking economy and runaway inflation. With high unemployment, consumers have less money to spend. Add inflation, and the money they do have is worth less and less every day. If you're on a fixed income, inflation erodes the value of your monthly check. And if you've managed to save some money, inflation eats away at its value, too. Inflation is a real confidence killer in an already depressing economic environment .
STAGFLATION IN 1970S
Prior to the 1970s, economists thought it was impossible to have both a stagnant economy and high inflation. According to the economic principles of John Maynard Keynes, an influential British economist, inflation was a byproduct of economic growth. For Keynesians, it's all about supply and demand. When demand is high -- as it is during a booming economy -- then prices go up. What the Keynesians didn't realize was that there were other powerful economic forces that could throw inflation into an upward spiral. To really understand how stagflation works, you have to take a trip back to the 1970s.
The word stagflation didn't even exist until the 1970s. From 1958 to 1973, the United States experienced what's known as the "Post-War Boom." Gross annual products in Western nations grew by an average of 5 percent annually, fueling a slow but steady rise in prices (inflation) over the same period. There were six quarters of shrinking Gross Domestic Product (GDP) growth, while inflation tripled in 1973, rising from 3.4% to 9.6%. It remained between 10-12% from February 1974 through April 1975. Unemployment was at 6.1%, a result of the economy contracting for three quarters. why did things go sour in the 1970s? Many experts blame the 1973 oil supply shocks, when OPEC cut its quota and prices quadrupled. This did trigger some oil price inflation. However, it took fiscal and monetary policy combined to create this extreme stagflation. It turns out that the Federal Reserve's monetary policy during the boom years of the late '50s and '60s was unsustainable. The economists at the Fed were diehard Keynesians who believed in something called the Phillips Curve. The Phillips Curve charts the relationship between unemployment and inflation. Historically, when unemployment is low, inflation increases, and when unemployment is high, inflation decreases. It all started with a mild recession in 1970. In the 1960s, the Fed believed that the inverse relationship between unemployment and inflation was stable. The Fed decided to use its monetary policy to increase overall demand for goods and services and keep unemployment low. The only tradeoff, economists believed, would be a safely rising rate of inflation Unfortunately, they got it wrong. The result of unnaturally low unemployment in the 1960s was something called a wage-price spiral. The government poured money into the economy to increase demand, making prices rose. Workers, noting the rise in prices (inflation), expected their wages to rise accordingly. For a while, employers were willing to raise wages, but then inflation began to rise faster than wages. Workers weren't willing to supply labor for lower wages, so unemployment increased even as inflation continued to rise. But the wage-price spiral alone wasn't enough to trigger killer stagflation. The real kicker was the OPEC oil embargo of 1973, which brought oil prices to record new levels. Prices skyrocketed, not only at the gas pump -- where long lines and shortages were common -- but across all U.S. industries. In 1970, inflation was 5.5 percent. By 1974, it was 12.2 percent, and then it peaked at a crippling 13.3 percent in 1979. The stock market ground to a halt. From 1970 to 1979, the S&P 500 returned an average of 5.9 percent annually. But when you subtract for inflation (average 7.4 percent annually), the market lost value every year. The annual return on bonds was 2.6 percentage points lower than inflation.
President Richard Nixon was running for re-election, and looked for a way to boost growth without triggering inflation. On August 13 1971, Nixon and his aides formulated four economic policies that would succeed in getting Nixon re-elected. Without realizing it, they also sowed the seeds for stagflation. First, Nixon instituted wage and price controls, freezing businesses' ability to raise prices in the U.S. When import prices rose, U.S. businesses couldn't raise prices to remain profitable. Instead, they had to reduce costs. Since they couldn't lower wages, they had to lay off workers. This raised unemployment, reducing demand, and slowing economic growth. Why did import costs rise? This was a result of Nixon's second action -- removing the U.S. from the gold standard, which had kept the dollar's value tied to a fixed amount of gold. Nixon did this to prevent a run on the gold reserves at Fort Knox. Under the Bretton Woods Agreement, most countries pegged the value of their currencies to either the price of gold or the dollar. This turned the dollar into a global currency. As a result, demand for the dollar rose. The crisis was precipitated when Great Britain tried to redeem $3 billion for gold. When Nixon took the U.S. off of the gold standard, the price of gold skyrocketed -from $35 an ounce to $120 an ounce. At the same time, the value of the dollar plummeted. The result? Import prices rose. To fight inflation, the Fed kept raising the Fed funds rate, reaching a peak of 20% in 1979. However, instead of signaling the market and being consistent, the Fed did so in a "stop-go" fashion. This confused businesses, many of whom kept prices high.
CAUSES OF STAGFLATIONDifferent economists sought to explain the phenomenon of stagflation differently. Three leading views are given below:
Keynesian View:Keynesian economists blame supply shocks for causing stagflation. They cite surging energy costs or surging food costs, for example, as the cause of economic woes. Monetarists cite overly rapid growth in the money supply for causing too many dollars to