Feb 25 2008

Stagflation – a blast from the past could mean trouble for US economy

Stagflation??Inflation gets a new focus along with recession worries – Feb. 21, 2008

As we begin our studies of the theories underlying the aggregate demand/aggregate supply model in AP Macroeconomics, it is useful to look in the news to see if we can try and understand how these theories apply to the real world. In the US, it appears as if a dangerous economic phenomena that plagued the country in the early 1970’s may be returning to wreak its havoc among households and policymakers.

Stagflation, “the unwanted combination of stagnant economic growth and destructive inflation”, has emerged in America today, in the face of weak aggregate demand and rising unemployment, combined with rising costs to firms thanks to energy costs and food prices.

Recession has been getting so much attention lately that it’s been easy to forget about the threats posed to the U.S. economy by inflation.But inflation worries are now back in focus in a major way. Oil prices hit a record of $101.32 a barrel in trading Wednesday, and was briefly above $100 again Thursday

Meanwhile, the Consumer Price Index, the government’s key inflation reading, showed a 4.3% rise in overall prices over the past 12-months. That reading has risen steadily from only 2.0% last August. Even stripping out volatile food and energy prices, the so-called core CPI posted the biggest seasonally-adjusted one-month jump in 19 months.

Typically inflation is experienced during the expansion phase of the business cycle, and is accompanied by falling rates of unemployment and increases in output, both positives for the economy as a whole. This type of inflation presents policy makers with clear solutions: reign in aggregate demand through contractionary fiscal and monetary tools, slow the rate of expansion, and stabilize prices.

The inflation that presents policy makers with a greater challenge, however, is that experienced by America today, which is cost-push in nature. Combined with weak aggregate demand, the Federal Reserve and the government’s hands are tied when it comes to intervening to restore price level stability. Traditional contractionary methods like raising taxes and interest rates will exacerbate the weak aggregate demand as households and firms reduce their spending. This will worsen the “stagnation” (low to negative growth) the economy has experienced over the last couple of quarters, and will not solve the problem of rising production costs, which are rooted in exogenous factors like energy and food prices.

Apparently, the Fed, in deciding to cut interest rates by 1.25% in the last two months, failed to consider the inflationary effect this may have:

Typically, slower growth or an actual recession cuts demand for products enough to curb prices. Based on the minutes from the Fed’s latest meetings, that seems to be what the Fed is banking on to keep inflation under control…

David Rosenberg, the chief North American economist for Merrill Lynch, wrote in a note Thursday that inflation should not be a major worry. Rosenberg is one of a growing list of economists who believe a recession has already begun.

He argued that commodity prices have only a limited impact on the cost of final goods and that wage growth is a bigger contributor to inflation. A weak job market should keep wages from rising sharply.

In other words, as the US enters a recession and unemployment increases, wages will cease to increase and may even fall. The fall in wages will lower firms costs, shift aggregate supply outward, and reduce the threat of inflation. But in today’s global economy, factors besides domestic wages, such as the weakening dollar and growing demand for America’s output from abroad, must be considered when considering inflation risks:

The weakening dollar is a concern since it raises the price of dollar-denominated commodities, such as oil and other raw materials, as well as imported goods…

Ritholtz said that overseas demand from growing markets such as China and India are likely to keep prices for many goods high, even if consumption of those products falls in the United States.

“Unless we see a significant U.S. recession that causes a slowdown overseas, inflation may be stickier this time around,” he said.

Once again we are witnessing the complex interactions of the world’s economies in play. Stagnant growth in the US combined with a weak dollar may lead to a slowdown of growth in China, which depends on US consumers as a destination for its exports. Ironically, if the US is to avoid stagflation, one of the most challenging macroeconomic problems to fix, it may just depend on a slowdown in growth of aggregate demand in China, which consumes not just an ever-growing proportion of the world’s raw materials, but a growing proportion of America’s own output as well. A slowdown in China would relieve pressure on input prices of raw materials, and reduce US export demand, dampening both the demand and supply side inflationary pressures in the US.

For a graphical portrayal of stagflation using the aggregate demand/aggregate supply model of the macroeconomy, click on the graph above.

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9 responses so far

9 Responses to “Stagflation – a blast from the past could mean trouble for US economy”

  1. kevinyehon 26 Feb 2008 at 12:39 am

    Like I was saying in a comment on an earlier blog post, the weakened dollar is viewed as a bad thing by many people, and I guess this is why. The domestic situation caused by the weak dollar has caused inflation rather than deflation although the economy is shrinking. These two factors together are causing stagflation, which causes people to have lower wages and more unemployment while at the same time having an increase in prices. this could become extremely harmful to the economy.

  2. optional.xuon 26 Feb 2008 at 11:18 pm

    yeah that definitely sucks. I mean, understandably the economy is weakening and the Fed has to cut interest rates to get people spending so that the economy as a whole can move back into growth. However, the fact that price levels are rising and unemployment is growing is killing everybody. Personally, I'm a bit scared to go back to the United States for university. I'm not sure what's going to happen with the dollar and price levels.

  3. Christina Huon 27 Feb 2008 at 12:21 am

    Ah no! Cutting interest rates is bad cuz then inflation outruns interest, and then the loaners, banks, etc. get the raw end of the deal and the money they get back is worth less and less. Over time, they'll slowly lose value. But then again, there are always two sides to the same story, so it's good for borrowers and people in debt and such.

    Anyway, I just want to add, I do think it's pretty cool how everything is so connected. Everything depends on something else, as is apparent in the case with America's salvation possibly lying in slower growth of China's aggregate demand, which may happen because of stagflation in the States, which will then reduce input costs, which will then ameliorate the cost-push situation, which will then help America get back up on her feet, which will once again increase aggregate demand in China, which will then push up input costs, which may then induce another bout of cost-push inflation… anyway, I've confused myself somewhere along the way, so I'll just stop now. :P

  4. Charlie.Gaoon 28 Feb 2008 at 11:17 am

    What the government should do is apply the Fiscal policy. Tax reduction and increased government spending. Stagflation is caused by a cost-push inflation, where aggregate supply curve shifts left. In order to counteract this decrease in GDP, there should be means taken to increase aggregate demand so that there will be economic growth.

  5. Nicole Wongon 28 Feb 2008 at 9:04 pm

    In the business cycle, recessions are followed by expansions. If the U.S. is experiencing a recession at the moment, would stagflation "hurry up" the process of this recession and quickly bring forth expansion? And if that were the case, shouldn't people be glad for stagflation (or at least in the long run)? The period of cyclical unemployment and lack of economic growth would take up a shorter period of time in this case, so the economy could resurrect itself once the recession was over.

  6. alicesuon 28 Feb 2008 at 11:50 pm

    While this blog post points out that the U.S. is hoping that the inflation caused by the weak dollar will be deterred by decreasing aggregate demand from abroad, the latest post on this blog specifically pointed out an actual RISE in consumption in China. As China continues to grow at a breathtaking pace and increases the living standards of its people on the way, the Chinese are also become apt to spend more and more… in this way, it looks like the U.S.' problems of stagflation will only be exacerbated as they enter into recession, yet continue to experience inflation due to foreign nations' increased consumerism and demand for the U.S. goods that have become significantly cheaper on the world market.

  7. Claire Mon 29 Feb 2008 at 1:40 am

    well stagflation can be the worst situation

    worse than inflation and recession as well.

    The value of price is decreased, and the economy is getting in to a worse situation. Therefore, the government should use the Fiscal Policy reducing tax, and increasing government spending. Stagflation is caused by a cost-push inflation,therefore, there should be more increased demand to shift the curve to the right, and make the GDP increase.

  8. Michael Dailyon 02 Mar 2008 at 8:25 pm

    Well, like Kevin said, the value of the dollar is declining, which has resulted in inflation. And since output has also been declining the Fed has really been put in a pickle. They can try to improve output and GDP, but at the same time they may be bidding the value of the dollar lower and lower. This is why stagflation is so difficult to fix. In the US this was experienced in the 1970s when the economy underwent a much worse recession than it currently has. In addition to the economic effects of stagflation, the dilemma it creates for the government, may result in the people trusting the government less and less, which can mean less spending and further detrimental impacts on GDP. However, I read that the chairman of the Federal Reserve Board recently said that he did not think the U.S. in it's current economic state would not have much stagflation. He expects the U.S. to soon rebound from this recession and begin significant growth again. Many economists disagree, but who really knows what is going to happen to the U.S. economy.

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