UPSC Essentials: One word a day – Stagflation

Subject: Economy

(Relevance: High value for prelims-UPSC asks questions around key terms from the economy. Conceptual clarity is a must for economic terms. Solve MCQ below to consolidate your concept.)

Why in news?

India is expected to witness slowing growth and faces an upside risk to the fiscal deficit owing to the recent excise duty cuts on fuel, but it has a low risk of stagflation owing to prudent stabilisation policies, the Department of Economic Affairs said in its Monthly Economic Review for May 2022.

What is Stagflation?

—Stagflation is a term that defines a situation characterized by a simultaneous increase in prices (inflation) and stagnation of economic growth.

— Stagflation can also be defined as a period of inflation combined with a decline in the gross domestic product (GDP).

— The situation may comprise of following elements-

1) growth rate of the economy slows down

2) the level of unemployment remains steadily high

3) yet the inflation or price level remains high at the same time.

—The term Stagflation was coined by Iain Macleod, a Conservative Party MP in the United Kingdom, in November 1965. It was the time when many developed economies experienced rapid inflation and high unemployment as a result of an oil shock.

Why is stagflation ‘worst of both worlds’?

— Typically, inflation rises when the economy is growing fast. That’s because people are earning more and more money and are capable of paying higher prices for the same quantity of goods. When the economy stalls, inflation tends to dip as well – again because there is less money now chasing the same quantity of goods.

—Stagflation is said to happen when an economy faces stagnant growth as well as persistently high inflation. In other words, the worst of both worlds. That is because with stalled economic growth, unemployment tends to rise and existing incomes do not rise fast enough and yet, people have to contend with rising inflation. So people find themselves pressurised from both sides as their purchasing power is reduced.

—Simply put, stagflation is a contradiction. Slow economic growth would likely lead to an increase in unemployment but should not result in rising prices. This is the problem with this phenomenon —an increase in the unemployment level results in a decrease in consumer spending power.

What is the most famous case of stagflation in history?

—The most famous case of stagflation happened in the early and mid-1970s when OPEC (The Organisation of Petroleum Exporting Countries), which works like a cartel, decided to cut supply and sent oil prices soaring across the world.

—On the one hand, the rise in oil prices constrained the productive capacity of most western economies that heavily depended on oil, thus hampering economic growth. On the other hand, the oil price spike also led to inflation and commodities became more costly. For instance, just in 1974, the oil prices went up by almost 70%; consequently, inflation in the US, for example, reached almost double-digits.

—The net result was lower growth, higher unemployment, and higher price level.

Point to ponder: What are the causes of stagflation? What is the cure for stagflation?

MCQ (attempt after reading the article)-

Which of the following statements with respect to stagflation is/are correct?

1) growth rate of the economy slows down

2) the level of unemployment remains steadily high

3) increase in consumer’s purchasing power

a) 1 and 2 only                                    b) 1, 2 and 3
c) 1 and 3 only                                    d) 1 only

( sources: investopedia.com, Explained: Is India facing stagflation?)