Question

Explain why stagflation (rising prices coinciding with declining output) is difficult to reconcile with a stable FE curve.

Answer 1

Stagflation refers to a period of economic stagnation along with inflation i.e. there is decline in economic activity or loss of gross domestic product along with a rise in prices in the economy i.e. there is inflation with falling output levels. This seems like a contradictory situation as inflation is generally associated with higher economic growth and output but it can happen due to economic shocks in the economy.

FE curve refers to the full employment curve. It shows a relationship between the level of employment or output and interest rate in the economy. A stable FE curve will be a vertical line at the full employment level of output since an economy will produce at full employment level irrespective of the rate of interest when it is operating at stable FE curve. The economy will be at full employment level.

Since during the period of stagflation, there is declining output growth i.e. people's demand for goods is falling therefore firms would decrease their output and hence would employ lesser number of people, so there would be unemployment in the economy. So it means the economy will not be operating at full employment level hence the FE curve won't be stable or in other words economy would not be on the stable FE curve when there is stagflation in the economy.

Therefore, it is difficult to reconcile stagflation with stable FE curve as there can either be stagflation or full employment in the economy but both can't take place simultaneously.