Stagflation refers to an economic situation marked by stagnant economic output and high price inflation. The idea became popular during the 1970s when the U.S. economy witnessed high price inflation due to the oil shock as well as an economic recession marked by negative economic growth. Economists at the time could not explain the prevalence of high price inflation and stagnant economic output at the same time. The prevailing notion among economists back then was that an economy can either experience high price inflation or stagnant economic output, but never both at the same time.
Unemployment and inflation
The idea of stagflation is closely linked to the Phillips curve which tried to establish that there was a negative empirical relationship between unemployment and inflation. That is, according to the Philips curve, when unemployment is high, inflation is low and when unemployment is low, inflation is high. The supposed negative relationship between unemployment and inflation was explained by Keynesian economists as a natural phenomenon caused by the prevalence of sticky prices. According to these economists, unemployment in an economy rises when wages fail to drop quickly enough to adjust to changing economic conditions. Workers are seen as unwilling to accept a cut in their wages, thus forcing businesses to let go of some of their employees in order to adjust to higher wages instead of trying to lower wages. This can affect the overall output of an economy as fewer people are now employed.
Many economists during the time, in fact, came to believe that it was the duty of central banks to carefully manage price inflation in such a way that unemployment is kept within reasonable limits. Inflation was supposed to be maintained at a certain level such that there is no excess unemployment and the economy is functioning at its full capacity. The belief among economists was that workers could be tricked into accepting lower real wages (but higher nominal wages) when prices rise at a certain rate, thus ensuring that workers are employed and the economy continues to function at full capacity.
Rational expectations model
The prevalence of both high price inflation and stagnant economic output in the 1970s, however, forced economists to reconsider their economic models. There was the need for alternative economic models that could explain the stagflationary environment of the 1970s better than the prevailing Keynesian model. The rational expectations model was one of the alternative models proposed to explain stagflation. According to this model, workers could not be as easily tricked by central banks as assumed by Keynesian economists. The proponents of the rational expectations school argued that when workers observe that prices rise at a certain rate over time, they are likely to demand higher wages in order to beat price inflation and at least maintain their real wages. In that case, central banks cannot trick workers so easily and high inflation and high unemployment may prevail at the same time.
Economists from other schools of thought have also tried to independently explain stagflation. Some, for instance, have argued that even though prices may be sticky and inflation could trick some workers, the economy does not function in a mechanistic way as assumed by the Keynesians. For instance, in the Keynesian view prices rise only after the economy reaches full employment. But there may be no valid reason to believe why prices cannot rise at an aggressive rate while the economy is stagnant. This can happen, for instance, when a supply shock is met with ultra-loose central bank policy. The result could be stagnating economic output even as prices of goods rise aggressively due to rising money supply.
