The standard macroeconomic remedies for inflation or unemployment are considered ineffective against stagflation. For this reason, there is no universal agreement on the best way to stop stagflation. The policy difficulty stems from the fact that the normal response to the components of stagflation – recession and inflation – are diametrically opposed. Governments and central banks respond to recessions through expansionary monetary and fiscal policy, yet inflation is normally fought through contractionary monetary and fiscal policy. This places policymakers in an uncomfortable predicament.
Macroeconomics Theory and the Impossibility of Stagflation
The main reason shy monetary and fiscal policies are largely ineffective against stagflation is that these tools were built on the assumption that concurrent rising inflation and unemployment was impossible.
British economist A.W.H. Phillips studied inflation and unemployment data in the United Kingdom during the 1860s and 1950s and found that there was a consistent inverse relationship between rising prices and rising unemployment. Phillips concluded that times of low unemployment caused an increase in labor prices that led to rising costs of living. Conversely, he believed that the upward pressure on wages was relieved during recessions that slowed the rage of wage inflation. This inverse relationship was represented in a model that came to be known as the Phillips curve.
Prominent 20th-century Keynesian economists and government policy buffs such as Paul Samuelson and Robert Solow believed that the Philips curve could be used to gauge macroeconomic responses to counteract undesirable economic conditions. They argued that governments could assess the trade-off between inflation and unemployment and balance the business cycle.
The Phillips curve was so prominent that, during the 1950s, then-Chairman of the Federal Reserve Arthur Burns was asked what would happen if both rising unemployment and rising prices occurred. His reported response, “Then we would all have to resign,” is telling.
During the 1970s, however, the U.S. entered a period of concurrent increases in consumer prices and unemployment. It was quickly dubbed “stagflation” – the worst of both worlds. Confronted with a reality that was thought to be impossible, economists struggled to come up with an explanation or a solution.
Proposed Solutions to Stagflation
Keynesian economics fell into a period of disrepute after the 1970s and lead to the rise of supply-side economic theories. Milton Friedman, who had argued during the 1960s that the Phillips curve was built on faulty assumptions and that stagflation was possible, rose to fame.
Friedman argued that once people adjusted to higher inflation rates, unemployment would rise again unless the underlying cause of unemployment was addressed. He said that traditional expansionary policy would lead, in turn, to a permanently increasing inflation rate. He argued that prices must be stabilized by the central bank to stop inflation from spinning out of control, and that the government must deregulate the economy and allow the free market to allocate labor towards its most productive uses.
Most neoclassical or Austrian views of stagflation are similar to Friedman’s. Common prescriptions include the cessation of expansionary monetary policy and to allow prices to freely adjust in the market. Contemporary Keynesian economists, such as Paul Krugman, argue that stagflation can be understood through supply shocks and that governments must act to correct the supply shock without allowing unemployment to rise …