Question

What is stagflation? In the AD/AS model, what usually has to happen for an event of stagflation to happen in an economy (please give at least 2 examples of how this happens)? Once in a period of stagflation, what can governments do to counter this? What are the consequences of these policies? Show graphically and explain in words. You need to have 2 AD/AS graphs showing the movement from the optimal point of stagflation, and then starting in stagflation and showing the effect of policy.

Answer 1

Stagflation occurs where inflation and stagflation occur simultaneously. Supply shocks cause stagflation. During the 1973, OPEC increased or quadrupled oil price in international market. it affected supply or production cost in international market. Increased cost of production leads to the fall in output level. Fall in output level automatically gives rise to the price level.

Following is diagram:

Policy makers face the dilemma while dealing with stagflation:

• Some economists suggests that government use expansionary fiscal policy, as it will shifts the aggregate demand to right thereby causing rise in output level.
• Monetarists says that taxes should be increased and expansionary monetary policy should be pursued.

Policy makers need to select the contractionary and expansionary instruments carefully and appropriately considering possible outcomes.