There is a co-existence of inflation and unemployment. The word stagflation comes from stag and inflation means the coexistence of inflation and unemployment.
If there is in the economy infrastructure, administrative defectiveness, mismanagement, instability in social and political affairs, and dishonesty everywhere then uncertainty and insecurity are observed in production. Investment reduces instead of increasing it.
Consequently, unemployment arises due to less investment. Production decreases and then the price level increases. Production cost increase due to an increase in the price level. Aggregate supply decreases. Therefore, inflation and unemployment co-exist here.
Causes of stagflation (this concept is related to the cost-push inflation)
The causes of stagflation are as follows:
- If there is a shortage of inputs then production decreases and employment reduces and the price level rises.
- When there is an increase in the input price then production as well as employment decreases and the price level increases.
- If the money wage rate is higher for the labor movement then the production cost increases and stagflation occurs.
- If there is infrastructural weakness then stagflation is observed. Some infrastructural viewpoints are as below:
- Underdeveloped education system
- Poor healthcare service
- Poor transportation system
- Lacking in the availability of gas and fuel
- Unfavorable situation for flourishing technology
- If a monopoly environment is prevailing then prices of commodities are increased in order to earn extra profit. Consequently, production as well as employment is reduced. Stagflation or inflation with unemployment is observed in the economy.
- Administrative complexity, inefficiency, and mismanagement may result in administrative system loss. As a result, the price level rises and employment decreases.
- A fall in law and order situation, lack of the rule of law, and political unrest may create stagnant conditions in economic activities. For this, stagflation may arise.
Stagflation creates a dilemma
Stagflation indicates the coexistence of economic depression, inflation, and unemployment. It creates a great crisis regarding policy making.
For facing inflationary pressure contraction is effective to influence the aggregate demand. But this policy will enhance more unemployment.
On the other hand, only unemployment measure through extensive fiscal policy will create more inflation and price hiking.
In this situation, the policy makers face a dilemma. That is why stagflation creates a policy dilemma whether contraction of monetary and fiscal policy or extensive fiscal or monetary policy will be helpful for minimizing stagflation or removing the coexistence of unemployment and inflation.
Ways to control stagflation
Now the question is that the dilemma is created by stagflation. But how to remove the crisis? To remove stagflation through influencing aggregate demand cannot bring about a positive result.
Because influencing aggregate demand through contraction in fiscal and monetary policy may create unemployment. On the other hand, if aggregate demand is enhanced then inflation is created.
Production is enhanced through reducing production cost. Thus, this aggregate demand is increased and stagflation may be controlled.
If aggregate supply can be increased then both price levels will be reduced as well as it will increase employment. Therefore, the government can take the following steps regarding the control of stagflation:
- Subsidy: If a subsidy can be provided the production cost will be lowered, employment will be created, and stagflation will be controlled.
- Taxes on imported goods: Here the input prices decrease, production cost also decreases and thus production as well as employment is enhanced.
- Infrastructural development: If in the economy, transportation or communication facilities are provided and gas, and electricity supply may be facilitated then production may be increased. As well as employment is created as well as the price level will be lowered; that is inflation may be controlled.
- Control of monopoly: Monopoly, black marketing, etc must be drastically controlled. Then the normal business environment in the production system and abnormality will be removed with unemployment. So higher price level will be controlled.
- Administrative control: Administrative complexity, inefficiency, and mismanagement are to be removed in order to lower the production cost. Consequently, inflation as well as unemployment will be possible to manage.
- Others: Lastly social, law and order situation, social security, and political stability will bring about economic stability or controlling stagflation. Here the aggregate supply curve is shifted to the right.