Question

1. What is meant by stagflation? Draw a graph that depicts stagflation using the AS-AD framework. Is an active monetary policy likely to be effective under stagflation? Why or why not?

Answer 1

Stagflation

Stagflation is an economic cycle in which there is high rate of inflation and stagnation. Inflation is when prices of commodities are at an increasing state. Stagnation occurs when an economy faces slow economic growth rate (decline in production). An economy going through stagflation faces high rates of unemployment.

Simply, stagflation is an economic situation in which prices are rising, there is a lack of job opportunities, and business firms are not performing well. It is a period of slow economic growth or when the economy is shrinking.

The condition of stagflation can be illustrated with the help of the following diagram:

As shown in the diagram, the initial level of output was Y1 with a general price level of Y1. The output or total supply curve shifts from AS1 to AS2. This states that the supply of goods and services in the economy has declined.

The figure also shows that the general price level of goods and services has increased from P1 to P2 even when the level of output has decreased. This is the rare economic condition of stagflation.

Monetary Policy

The Central Bank could use monetary policy to try and reduce inflation. Higher Interest rates increase the cost of borrowing and this will reduce aggregate demand (AD). This will be effective for reducing inflation, but, it will cause a bigger fall in GDP. Therefore, the Central Bank may be reluctant to target inflation when growth is already low.