Stagflation
Stagflation is thought to occur when there is an adverse supply shock (a sudden increase in the price of oil or a new tax, for example) that causes a subsequent jump in the “cost” of goods and services (often at the wholesale level). In technical terms, this results in contraction or negative shift in an economy's aggregate supply curve. Stagflation results when economic growth is inhibited by a restricted supply raw materials. That is, when the actual or relative supply of basic materials (fossil fuels (energy), minerals, agricultural land in production, timber, etc.) decreases and/or cannot be increased fast enough in response to rising or continuing demand. The resource shortage can be caused either by an actual physical shortage of a resource or because other factors such as taxes or bad monetary policy have affected the “cost” or availability of raw materials and created a “relative scarcity” of resources. This is consistent with the “cost-push” inflation factors in neo-Keynesian theory.
Below is the PC Model where the circular flow approach to money and the stock approach are combined. While the PC model is not suitable for simulation the event of stagflation, it can assist in establishing how policy can be modified to deal with the event. Analysing the PC Model with expectations provides a way to study the possible effects of stagflation.
PC Model
PCEX Model
Y = C + G (4.1)
In stagflation times then Ywill remain the same, or decrease. Government Expenditures remain the same or decrease in stagflation times; however the government must try to battle stagflation maintain or increase Y.
YD = Y – T + r-1 . Bh-1 (4.2)
Stagflation is a period of inflation combined with stagnation. The disposable income of households remains the same or decreases marginally.
T = Ø . (Y + r-1 . Bh-1) (4.3)
The personal income tax rate remains the same but if Y and r-1 decrease and Bh-1 increase, taxes fall.
V = V-1 + (YD – C) (4.4)
The wealth of households will remain the same or decrease as consumers start to save in stagflation times. However consumers have to spend more for domestic products, i.e. groceries, since inflation rises C (consumption) increases. Therefore less wealth is saved in the present period and so less wealth saved overall.
C = α1 . YDe + α2 . V-1 (4.5E)
The consumption during stagflation will increase since inflation rises in stagflation - the consumer has to spend more for to get the same amount of goods as before.
Hh = V - Bh (4.6)
The money held by households will be the same or less since households invest more in Treasury bills since they benefit from higher interest rates. However a liquidity trap may arise if the interest rates are so low that there is no difference between household cash and household bonds e.g. treasury bills.
Bh/Ve = λ0 + λ1 . r - λ2 . (YDe/Ve) (4.7E)
The amount held in bonds depends on the marginal propensity to consume, the marginal propensity to consume out of regular income and the marginal propensity to consume out of past wealth (λ0, λ1 and λ2). Due to stagflation the proportion to consume out of past wealth and regular income will rise due to inflation and decreasing interest rates.
∆Bs = Bs – Bs-1 = (G + r-1 . Bs-1) – (T + r-1 . Bcb-1) (4.8)
This equation describes the government budget constraint, which is an identity illustrated by column 3 as shown in the PC model above. The equation simply says that the government deficit is financed by bills newly issued by the Treasury department (over and above bills which are renewed as they mature). The first term (G + r-1 . Bs-1) represents the total outlays of the government expenditures on services, purchased from the production sector and interest payments that must be made on the overall outstanding debt. The second term of the equation (T + r-1 . Bcb-1) represents the revenues of the government: its income tax revenue, and the profits which it receives from the central bank. Government expenditure will increase as many households invested in bonds while tax revenue will decrease so as to remain a growing economy to battle stagflation.
∆Hs = Hs – Hs-1 = ∆Bcb (4.9)
This equation describes the capital account of the central bank, as given in column 4 of the PC Model above. The additions of the stock of high powered money ∆Hs is equal to the additions in the demand for bills by the central bank ∆Bcb. The government issues bills to cover debt and so the amount issued in bills will be equivalent to the amount of money placed to cover all bills.
Bcb = Bs - Bh (4.10)
The demand for bills by the central bank is determined. The central bank is the residual purchaser of bills: it purchases all the bills issued by the government that households are not willing to hold given the interest rate. At present, this will be very small since mostly all households would have purchased the bills since they would be giving a greater interest rate than the nominal interest in the bank.
Hd = Ve - Bd (4.13)
This equation simply says that the money holdings are the discrepancy between the total household wealth and the demand for bills by households.
Ve = V-1 + (YDe - C) (4.14)
Total expected wealth accumulated depends on the expected current income and wealth accumulated in the previous period. During stagflation expectations will probably be never right as it is difficult to determine income in times of constant rising inflation and a stagnant economy. Therefore the expected wealth accumulated will be small due to rising inflation, and so very little income generated to save.
Bh = Bd (4.15)
Households invest in bills on the basis of their expectations with respect to disposable income that were made at the beginning of the period. The amount of bills held by households at the end of the period is exactly the same as the amount of bills demanded by households at the beginning of the period. Since interest rates are falling, there will be a hugh demand by households to invest their savings in bills. Also during stagflation the best households can do to battle this is through saving, so as to be prepared in hard times.
An Adverse Supply Shock
Below is an example of an adverse supply shock like a sudden doubling of the world price of oil, hits an economy and the dilemma of stagflation. Firstly here is the simple aggregate supply and demand curve given the potential output and the expected price level.
Such an adverse supply shock moves the economy up and to the left on the AS – AD diagram.
If the central bank wants to keep the supply shock from causing a recession, it increases the money supply and so pushes the aggregate demand curve up and to the right. Therefore it keeps production at a new equilibrium equal to potential output.
However increasing the money supply and pushing the aggregate demand curve up and to the right allows the price level to jump and inflation to accelerate.
If the central bank wants to keep inflation from accelerating in response to the supply shock, it must contract the money supply, raise interest rates and so shift the aggregate demand curve down and to the left (Bradford DeLong, 1998).
Although, trying to keep inflation from accelerating at the price of sharp fall in output, a deep recession and high unemployment is then likely.
Neither alternative is attractive. Being a central banker in a time of adverse supply shocks is not much fun.
Stagflation occurs when the economy isn’t growing but prices are, which is not a good situation for a country to be in (Investopedia ULC, 2008). The economy will first try to maintain momentum - that is, consumers and businesses will begin paying higher prices in order to maintain their current level of demand. The central bank may exacerbate this by increasing the money supply in an effort to combat a recession, for example by lowering interest rates. The increased money supply props up the demand for goods and services when it would normally drop during a recession. The solution to stagflation is to restore the supply of materials. In the case of a physical scarcity, stagflation is mitigated either by finding a replacement for the missing resource(s) or by developing ways to increase economic productivity and energy efficiency so that you can produce more with less input.
If the resource scarcity is being caused by flawed market intervention (i.e., bad government, etc.) then the solution is to eliminate the disrupting force on the market (e.g., better monetary policy, changes in tax laws) (Wikipedia, 2008).
The real factors that determine output and unemployment affect the aggregate supply curve only. The nominal factors that determine inflation affect the aggregate demand curve only. When some adverse changes in real factors are shifting the aggregate supply curve left at the same time that unwise monetary policies are shifting the aggregate demand curve right, the result is stagflation. Therefore so as to adjust to stagflation one must create a balance between the aggregate supply and aggregate demand so that the economy is neither in a recession or in stagflation. Therefore by modifying the PCEX model as discussed above and the simulation of a sudden shock to the system such as a double increase in oil, one can accommodate for the possibility of stagflation. The recessionary situation is exacerbated when a central bank expands the money supply as a means of fighting the recession - for example by lowering interest rates. The economy borrows more money to pay for defaults in loans and rise of oil but because oil is a non renewable resource and that it is very scrace, oil prices rise still further but only over the short-run (Wikipedia, 2008).
The economy must firstly restore the supply of materials, find a replacement for the missing resources, for example oil, and develop new ways to increase productivity and energy efficiency so as to produce more with less input so as to accommodate the possibility of stagflation. The economy must have better monetary policies and changes in the tax laws. If the economy increases government expenditure by enhancing skills in the workplace, the economy will start to boom by been more efficient, creating more exports and less unemployment and so the aggregate supply curve will move down and to the right. Furthermore being more efficient in the workplace creates cheaper output which contains only value added and not at the price of the inclusion of non value added. Therefore supplies will increase along with competition since been more skillful than other countries and so the aggregate demand will move down and to the right and so inflation will drop. If the aggregate demand moved down and to the left it would be in a recession.
Due to the subprime mortgage crisis, many banks and finacial service institutions are writing off huge amounts of debt since many loans are defaulting rapidly. To restore the money back in the economy that the banks have lost, banks must increase production by selling more products yet these products have to be to an extent riskfree, by taking on the correct client that has good credit ratings and will not default on their loans. Furthermore by increasing the sale of many of their products, they must take on more employees and decrease the price of their products, e.g. less interest paying rates, and so end the rise in inflation and stagflation. Governments must increase growth at the expense of giving grants to institutions to enhance workplace skills, i.e. skillnet, forfas and also decrease taxes. However at the expense of decreasing taxes, jobs in the government sector would be a concern.
References:
Bradford DeLong, J. (1998) “Supply Shocks: The Dilemma of Stagflation” [Online] available at: http://econ161.berkeley.edu/multimedia/ASAD1.html (accessed 20th March 2008)
Godley, W., and M. Lavoie (2007) Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, Palgrave Macmillan.
Investopedia ULC. (2008) Stagflation [Online] available at:
http://www.investopedia.com/terms/s/stagflation.asp (accessed 20th March 2008)
Wikipedia (2008) Stagflation [online] available at: http://en.wikipedia.org/wiki/Stagflation (accessed 20th March 2008)
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