Stagflation

For decades economists believed an economy could suffer high inflation or high unemployment but not both at once. Stagflation proved them wrong.

Stagflation is the uncomfortable combination of stagnant economic growth and high unemployment with high inflation occurring at the same time. It is troubling because it defies the conventional trade-off, and because the standard tools for fighting one of its symptoms tend to worsen the other.

Why it broke the textbooks

The dominant view, captured in the Phillips curve, held that inflation and unemployment moved in opposite directions: you could reduce one only by accepting more of the other. Stagflation, which struck many Western economies in the 1970s, shattered that comfortable picture by delivering both at once. It forced a rethink of macroeconomic theory and gave rise to ideas about expectations and supply shocks that the simple trade-off had ignored.

Where it comes from

Stagflation is typically driven by a supply shock, a sudden rise in the cost of a key input, such as the oil price spikes of the 1970s, that pushes prices up while simultaneously choking output and employment. It can also arise when inflation expectations become entrenched even as growth falters. Unlike demand-driven inflation, which comes with a booming economy, stagflation pairs rising prices with a shrinking one.

The policy dilemma

Stagflation is so feared because it traps policymakers. The cure for high inflation, tighter money and higher interest rates, deepens the stagnation and unemployment. The cure for stagnation, looser money and stimulus, feeds the inflation. There is no comfortable response, only a choice about which problem to tackle first and how much pain to accept. Taming the inflation of the 1970s ultimately required severe recessions deliberately induced by central banks.

Stagflation is a reminder that economies can fail in more than one way at once, and that the neat trade-offs of textbook models hold only under certain conditions. Its appearance reshaped macroeconomics, and its possibility still haunts policymakers whenever a supply shock threatens to raise prices and depress output together.