Question

. In 500 words or more, explain the topic. What causes stagflation and give examples of occurrences in our economy. Relate this topic to the Phillip’s Curve and demonstrate why this is a problem to traditional Keynesian thought. What would you recommend to the Fed when stagflation comes calling?

Answer 1

The 'Great Depression' resulted in the emergence of Keynesian economics. The classical economists argued that the recession and boom are the reality of economics and these cycles are inevitable. It also stressed that such cycles will correct themselves in the free economy and the government should not interfere in that mechanism. The market through price correction such as wage or interest rate will result in an automatic recovery.

However, the 'Great Depression' proved severe and John Keynes argued that prices do not correct themselves immediately rather they tend to be 'sticky' in the short term. This prolongs the recession and requires government intervention. The government with its capabilities can undertake an expenditure program that creates a multiplier effect in the economy. This acts as a stimulus and raises aggregate demand. The early recovery of the economy is also coupled with a decrease in unemployment.

Philip Curve also suggests the same fact. If the unemployment rate is higher than the natural rate then increasing the money supply in the economy will create a multiplier effect and the economy will get a boost. The money supply can be increased through fiscal policy such as tax or an increase in government expenditure. Alternatively, through monetary policy by reducing the interest rate or open market operations. It should be noted that any method which will increase the money supply will also increase inflation in the economy.

However, there is a problem. If the unemployment rate is already at its natural rate or below the natural rate then any measure to increase the money supply will increase inflation but will not result in any boost to the economy. Higher inflation and stagnated growth will create a situation that is called 'stagflation'. The US witnessed this phenomenon in the 1970s when there was high inflation of around 10% and stagnated growth.

Stagflation can be addressed through supply-side economics. The US had stagflation because it discouraged the supply in the market through wage-price controls. The government should not try to control the market mechanisms and it should actually remove the bottlenecks in the economy. The opening up of more sectors to private investment and abolishing any price control will reduce the bottlenecks in the economy that will negate the stagflation.