Stagflation is an economic situation that combines two problems: a stagnant economy and high inflation.

In other words, growth in the economy slows to a crawl (or even stops) at the same time that prices are rising quickly.

The word stagflation itself is a blend of “stagnation” (meaning sluggish or no growth) and “inflation” (rising prices)​

In practical terms, stagflation means three bad things are happening at once: slow (or negative) economic growth, high unemployment, and high inflation​

This scenario is unusual because, in normal economic cycles, high inflation typically happens during boom times, not when growth is flat.

But during stagflation, prices keep going up even though the economy is weak, which defies the usual logic of economics (normally, weak demand would curb price increases).

Stagflation is often considered a “worst of both worlds” situation, posing a serious challenge for any economy experiencing it.

Stagflation

One of the worst things that can occur to a currency is the effect of stagflation.

It leaves very little room for central banks to move because they cannot raise interest rates enough to combat rising prices.

When prices rise disproportionately to interest rates, the value of the domestic currency depreciates.

This, in turn, reduces the purchasing power of consumers.

As such, foreign exchange markets usually see stagflation as negative for the domestic currency.

What causes stagflation?

Signs of stagflation include high rises in the price of consumer goods and services through high inflation, a reduction in Gross Domestic Product (GDP), and high unemployment.

There is no consensus among economists on the causes of stagflation. However, two main theories may be derived: supply shock and poor economic policies.

The supply shock theory suggests that stagflation occurs when an economy faces a sudden increase or decrease in the supply of a commodity or service (supply shock), such as a rapid increase in the price of oil.

In such a situation, prices surge, making production costlier and less profitable, thus slowing economic growth.

A second theory states that stagflation can be a result of a poorly made economic policy.

For example, the government can create a policy that harms industries while growing the money supply too quickly.

The simultaneous occurrence of these policies can lead to slower economic growth and higher inflation.

Why is stagflation important?

Stagflation is important to understand because it represents a nightmare scenario for both policymakers and ordinary people.

For consumers and families, stagflation can be very painful: high inflation rapidly erodes purchasing power, making everyday goods more expensive, while at the same time, a weak economy means wages stagnate or jobs are harder to find​

People may find that their paychecks aren’t keeping up with rising food, gas, and rent costs, leading to a drop in living standards.

For government and central bank officials, stagflation is notoriously hard to fix. It creates a policy dilemma:

  • If authorities try to fight inflation by raising interest rates or cutting spending, they risk slowing the economy even more and causing higher unemployment.
  • But if they try to stimulate growth by lowering rates or increasing spending, they risk fueling even more inflation.

This “catch-22” is what makes stagflation especially significant – it challenges traditional economic tools and forces economists to rethink their theories after the famous stagflation episodes of the 1970s.

In short, stagflation matters because it can lead to severe economic hardship and requires very delicate policy choices to address.

What are the consequences of stagflation?

Stagflation has several adverse consequences for an economy:

  • Reduced economic growth: The combination of slow growth and high inflation can lead to a decline in overall economic activity and potentially a recession.
  • Erosion of purchasing power: High inflation reduces the real value of wages and savings, making it more difficult for consumers to afford goods and services.
  • Increased unemployment: Stagnant economic growth and higher production costs can lead to job losses and reduced job opportunities.
  • Increased uncertainty: Stagflation creates uncertainty for businesses and consumers, making it difficult to plan for the future and make investment decisions.
  • Wage-price spiral: Rising prices during stagflation can lead to demands for higher wages, which in turn can further fuel inflation, creating a self-reinforcing cycle.
  • Misery Index: The “Misery Index,” calculated by adding the inflation rate to the unemployment rate, is a measure of the economic distress caused by stagflation

What is the difference between recession and stagflation?

A recession is a sustained decline in economic activity.

Stagflation is a sustained decline in economic activity combined with sustained high inflation.

While both stagflation and recession are undesirable economic conditions, they have distinct characteristics:

Feature Stagflation Recession
Definition Slow economic growth, high unemployment, and high inflation Significant decline in economic activity, typically lasting for several months
Inflation High Typically low or even deflationary
Policy Response More challenging due to conflicting needs to control inflation and stimulate growth Expansionary monetary and fiscal policies to stimulate demand
Duration Can persist for an extended period Usually shorter than stagflation

Stagflation can be worse than a recession because it is more challenging to address with traditional economic policies. In a recession, central banks can typically lower interest rates to stimulate growth. However, in stagflation, this action could worsen the existing inflation

What is the difference between stagflation and inflation?

While stagflation and inflation both involve rising prices, they are distinct concepts in economics:

Inflation

  • Inflation refers to a general increase in prices across an economy over a period of time.
  • It can occur for various reasons, including demand-pull factors (when demand outpaces supply), cost-push factors (when production costs increase), or monetary factors (such as an excessive money supply).
  • Inflation does not, by itself, indicate that an economy is stagnant. In fact, inflation often accompanies periods of robust economic growth, where demand is high.

Stagflation

  • Stagflation, on the other hand, is a specific scenario where inflation occurs simultaneously with stagnation or contraction in economic output and rising unemployment.
  • In other words, while inflation alone might occur during a booming economy (where rising incomes keep up with higher prices), stagflation is particularly troublesome because it happens when the economy is not growing, leaving consumers with less real income while prices increase.

To put it simply, inflation is about rising prices, while stagflation is about rising prices and a failing economy.

This key difference makes stagflation especially challenging because the usual policy responses to inflation (like raising interest rates) might further depress economic growth, and policies designed to boost growth can make inflation worse.

Here’s a table summarizing the key differences between stagflation and inflation:

Feature Stagflation Inflation
Economic Growth Slow or negative Usually positive
Unemployment High Usually low
Policy Response More challenging due to conflicting needs Can be addressed with traditional monetary and fiscal policies
Frequency Rare More common
Duration Typically longer Can be short-term or long-term
Impact on Economy More severe and difficult to recover from Can be managed with appropriate policies

How is stagflation related to economic growth and inflation?

To understand stagflation, it’s helpful to first look at the usual relationship between economic growth and inflation. Typically, when an economy is growing robustly:

  • Demand Rises: Increased consumer and business demand can push prices up, a phenomenon known as demand-pull inflation.
  • Employment Increases: Growth usually reduces unemployment, and as more people work, spending increases, which can further drive inflation.
  • Balanced Trade-offs: Economists have long believed in the Phillips Curve, which suggests an inverse relationship between inflation and unemployment. In other words, higher inflation is often accompanied by lower unemployment and vice versa.

Stagflation defies these normal patterns:

  • Low Growth Despite Rising Prices: Even when economic output is stagnant or contracting, prices keep climbing. This suggests that factors other than booming demand, like supply shocks or structural issues, are driving inflation.
  • Disrupted Phillips Curve Relationship: The traditional inverse relationship between inflation and unemployment breaks down. Instead of low unemployment during periods of high inflation, stagflation brings both high inflation and high unemployment.
  • Supply-Side Constraints: One common explanation for stagflation is a supply shock, such as a sudden spike in oil prices. When the cost of essential inputs rises sharply, businesses pass these higher costs on to consumers, resulting in inflation even when demand is weak.

This combination of slow or negative growth and high inflation means that standard economic policies, which typically target one issue at a time, become less effective when both problems occur together.

How does stagflation affect a country’s currency?

Stagflation can significantly impact a country’s currency:

  • Depreciation: High inflation erodes the value of a currency, making it less attractive to foreign investors and leading to depreciation in the exchange rate. This can be further exacerbated by a decline in foreign investment and capital flight, as investors seek safer assets in other countries.
  • Reduced purchasing power: As the currency depreciates, its purchasing power declines, making imported goods more expensive and further fueling inflation. This can create a vicious cycle where depreciation and inflation reinforce each other.
  • Loss of confidence: Stagflation can lead to a loss of confidence in the economy and the currency, further exacerbating the depreciation. This can make it difficult for the country to attract foreign investment or access international financial markets.
  • Difficulties in servicing foreign debt: For countries with significant foreign debt, stagflation can make it more challenging to service those debts. As the currency depreciates, the cost of repaying foreign debt in local currency increases, potentially leading to financial instability.
  • Optimum Exchange Rate: The concept of an “optimum exchange rate” suggests that there is an ideal exchange rate that balances a country’s economic objectives. However, stagflation can make it difficult to achieve this optimum rate. For example, if a country tries to maintain a fixed exchange rate during stagflation, it may need to implement restrictive monetary policies that could further harm economic growth.

What are three historical examples of stagflation?

Stagflation is relatively rare, but it has occurred in various forms in recent decades. Here are four real-world examples:

The 1970s: The Classic Stagflation Episode

The 1970s are perhaps the most famous example of stagflation. During this period, many advanced economies, particularly the United States, experienced a simultaneous surge in inflation and stagnation in economic growth. Several factors contributed:

  • Oil Price Shocks: In 1973 and again in 1979, the Organization of the Petroleum Exporting Countries (OPEC) drastically raised oil prices. Because oil is a fundamental input in almost every economic sector, higher oil prices increased costs for producers and consumers alike, triggering widespread inflation.
  • Policy Missteps: Prior to the shocks, expansive fiscal and monetary policies had already pushed inflation upward. When the oil price shocks hit, these policies exacerbated the inflationary environment even as economic growth stalled.
  • Labor Market Strains: High inflation led to wage demands, which in turn raised production costs, fueling a vicious cycle of rising prices and unemployment.

The stagflation of the 1970s taught economists a harsh lesson: economies could indeed suffer from the simultaneous pressures of inflation and stagnation, forcing a rethinking of established economic models.

2008 (United States / Global)

In the lead-up to and during the Great Recession of 2008, there were stagflation-like conditions. Oil and commodity prices spiked in 2007-2008, driving inflation higher even as economic growth stalled.

In the United States, for instance, overall inflation climbed above 5% in mid-2008 while the economy was shrinking, and unemployment was rising.

This was highly unusual: Americans faced rapidly rising gasoline and food costs at the very moment the economy was in recession.

Although the inflation surge was relatively brief (prices fell the next year), the 2008 episode is often cited as a “stagflation scare” because it combined recessionary conditions with sharp price increases.

2015 (Brazil)

Brazil provides a clear example of stagflation in the mid-2010s. By 2015, Brazil’s economy had fallen into a deep recession while it also grappled with high inflation.

The country was in a “very difficult situation of stagflation,” with the economy contracting (GDP growth was around -3.5% in 2015) and annual inflation soaring to about 9-10%. Unemployment climbed as well during this period.

Brazil’s central bank was forced to hike interest rates to 14.25% to try to tame inflation, even though the economy was shrinking.

This combination of declining output and surging prices hurts Brazilians’ purchasing power and confidence.

The 2015 Brazil case shows how policy missteps and external shocks (like falling commodity prices at the time) can trap an economy in stagflation.

2021-2022 (Global Economy)

In the aftermath of the COVID-19 pandemic and with the disruption of the Ukraine war, many economies experienced conditions akin to stagflation.

Global growth rebounded in 2021 but then slowed sharply in 2022 while inflation jumped to multi-decade highs in numerous countries.

For example, energy and food supply shocks pushed prices up around the world. Europe and the UK saw annual inflation rates in the high single digits to over 10% even as their economies slowed to near-zero growth.

The World Bank in mid-2022 warned that the global economy was entering a period of “feeble growth and elevated inflation,” raising the risk of stagflation.

Though labor markets in some countries (like the U.S.) remained relatively strong, the combination of weak economic growth and high inflation was a major concern.

This recent episode drew comparisons to the 1970s and put stagflation back into the spotlight for policymakers.

Policy Responses

Addressing stagflation requires a delicate balance between controlling inflation and stimulating economic growth.

Policymakers face a dilemma, as traditional monetary and fiscal policies may not be effective in addressing both issues simultaneously. Some potential policy responses include:

Supply-side Policies

Supply-side policies are measures to increase productivity and improve the supply of goods and services can help address the supply-side constraints that contribute to stagflation. These policies may include:

  • Deregulation is to reduce barriers to business activity and encourage investment.
  • Investment in infrastructure to improve transportation, communication, and energy networks.
  • Education and training programs to enhance the skills and productivity of the workforce.

Monetary Policy

Careful monetary policy adjustments are necessary to control inflation without causing further economic stagnation. This may involve:

  • Gradually raising interest rates to curb inflation while closely monitoring the impact on economic growth.
  • Implementing measures to stabilize exchange rates and maintain confidence in the currency.

Fiscal Policy

Fiscal policy and targeted fiscal measures can be used to stimulate demand and support economic growth. These may include:

  • Tax cuts to encourage spending and investment.
  • Government spending on infrastructure projects to create jobs and boost economic activity.

Bottom Line

Stagflation affects every layer of an economy, from consumer confidence to international currency values. It occurs when an economy experiences stagnant or negative growth while inflation drives up prices, leading to significant hardships for households and posing daunting policy dilemmas for governments and central banks.