As the name suggests, it is a combination of the two words 'stagnation' and 'inflation'. It is a state of the economy characterized by high unemployment and inflation, with flat demand for goods and services. It requires immediate attention or else the economy may even fall into a recession. The term was first used by Iain Macleod in a speech to the British Parliament in 1965, and since then it has aptly come to describe a situation where the unemployment and inflation rates are constantly rising together.
Fixing the problem requires careful analysis and implementation of monetary policy because too much focus on one problem can cause the other issues to spiral out of control. Obviously, no country wants to experience high unemployment and inflation, and when they both occur at the same time, it can spell doom and gloom.
The causes can be seen in two different lights. In the first situation, stagflation can occur when a country suddenly receives a low supply of an item it heavily depends on (supply shock). As a result of this, the costs of production become very high, and any economic process becomes unprofitable. Prices of all commodities rise further up, slowing down the economy, and leading to a rise in unemployment. Milton Friedman famously described this situation as 'too much money chasing too few goods.'
Understanding this term also requires students to see the other possible causes of the condition. Faulty macroeconomic policies undertaken by the government could be another major reason. When the government increases monetary supply in the economy, it leads to inflation. On the other hand, when it heavily regulates the free market, it leads to stagnation and unemployment. Both these scenarios can occur individually, or concurrently as well.
Excessive levels will ultimately lead to slow growth and economic recession, so it is necessary to fix the problem as soon as possible. The 1970s saw a period of stagflation in the US economy due to rising prices of crude oil, and this ultimately impacted the United Kingdom and other countries of the world as well. In order to control the economy, appropriate monetary policies need to be implemented by the government.
The idea is to control inflation levels in the country, and this can only be achieved by controlling the money supply. It is for this reason that governments need to understand stagflation and how to go about solving it. When the economy is growing, the government should increase interest rates so that there is less money in circulation. On the other hand, when the economy is slowing it should lower interest rates so that there is more money pumped into the system.
Ensuring that employment levels are maintained at a respectable level will also help stabilize the economy. Balancing the two variables is something that requires experience and patience, and this is why many countries fall into the trap. Since unemployment and inflation rates should not rise together, the government needs to take preventive measures as and when it can.