In economics, stagflation refers to the combination of stagnation and inflation. Stagnation refers to slowing economic growth or recession. It is a period of low gross domestic product and high unemployment. Inflation refers to rising consumer prices. The combination of these two conditions makes for a troubled economy.
The term stagflation was first used by economists in the 1970s when both the U.S. and the U.K. were experiencing simultaneous stagnation and inflation. At that time much of the economic trouble was due to rising oil prices which can contribute to both inflation and stagnation.
Central Banks and Stagflation
Central banks have certain tools for counteracting unfavorable economic conditions. They can implement monetary policy tools to try to influence the conditions of the economy. Central banks can raise or lower interest rates, raise or lower reserve requirements, and buy or sell currency to influence money supply.
For example, if inflation is rising, a central bank can raise interest rates, raise reserve requirements, or purchase currency to reduce the money supply in an attempt to curb inflation.
And during a period of stagnation, if the economy is slowing down, the central bank can lower interest rates in an attempt to increase the money supply and stimulate business and economic activity.
However, when inflation and stagnation occur simultaneously, the tools of the central bank are not so simple to implement. For example, during a period of stagflation, a central bank could raise interest rates to fight inflation. But this would hurt the struggling economy. And the central bank could lower interest rates to stimulate the economy, but this would exacerbate inflation.
So one of the main reasons stagflation is such a problem is that central bank monetary policy is essentially unable to ameliorate the unfavorable economic conditions. Trying to fix one half of the problem only makes the other half of the problem worse. Additionally, it doesn’t matter which side of the problem they attempt to correct or influence.