TL;DR
Stagflation occurs when an economy experiences high unemployment, low or negative growth (recession), and price increases (inflation). Stagflation is difficult to handle because there are ways to combat recession and inflation independently, yet they conflict with one another.
Introduction
One approach to economic stagnation or negative growth is to expand the money supply, which lowers interest rates and makes borrowing money more affordable for firms. Having more money on hand leads to growth and higher employment rates, both of which serve to prevent or minimize a recession.
When inflation becomes out of control, economists and policymakers often try to slow the economy by reducing the money supply. One method is to raise interest rates, making borrowing money more expensive. Price increases have been stopped due to decreased demand from businesses and families.
Stagflation, on the other hand, is the worst of both situations, as it causes both a recession and excessive inflation. Let’s go over what stagflation is, what causes it, and what we can do about it in more detail.
What is Stagflation?
British politician and Chancellor of the Exchequer Iain Macleod created the word “stagflation” in 1965. The term, a combination of the words “stagnation” and “inflation,” refers to an economy with little or negative growth, high unemployment, and rising prices for goods and services.
Governments and central banks have difficulty dealing with stagflation because typical economic methods used to treat each crisis separately could worsen the other. Stagflation is uncommon in that it occurs while both unemployment and economic growth are high.
Because of its relationship to employment levels, gross domestic product (GDP) is a common indicator of economic health. Extreme stagflation, which occurs when both GDP and inflation underperform, could lead to a larger financial crisis.
Inflation vs. Stagflation
As we’ve seen, stagflation occurs when there is both inflation and poor or negative economic growth. Inflation can imply different things to different individuals, but it generally signifies that prices are rising. Another way to define inflation is the decline in the value of a currency.
The Reason for Stagflation is Occur
Stagflation is defined as the simultaneous fall in economic activity and supply of goods and services, which results in a decrease in the purchasing power of money. The historical context and opposing economic theories all play a part in establishing who or what is to blame for stagflation. The monetarist, Keynesian, and new classical models are only a few of the many concepts and points of view that give their explanations for stagflation. Let’s take a look at some examples.
Clashing Monetary and Fiscal Policy
The Federal Reserve System and other central banks manage the money supply and, hence, the economy. These regulatory measures are referred to as monetary policy. Fiscal policy, which includes government spending and taxation, also has a direct impact on the economy. However, uneven fiscal policy and monetary policy can cause inflation to spiral out of control and economic growth to stop. Stagflation is a possible effect of any policy mix that reduces consumer expenditure while increasing the money supply.
When the government increases taxes, for example, consumers have less money to spend. The central bank may cut interest rates while also engaging in quantitative easing (“printing money”). The government’s actions will stifle growth, and the central bank’s response—increasing the money supply—will usually result in higher prices.
The introduction of fiat currency
Many of the world’s greatest economies used to pegged their currency values to gold. Following World War II, there were significant reservations about the gold standard. The transition from the gold standard to fiat currency resulted in the removal of monetary limitations. While this may make central banks’ jobs simpler, it also increases the risk of inflation and price increases.
Supply Costs Are Increasing
Stagflation can also come from an increase in the cost of manufacturing, which raises the cost of goods and services for consumers. This is a supply shock, and it is especially essential to the energy sector. A surge in energy expenses, primarily owing to rising oil prices, is also causing consumers discomfort.
Stagflation is more likely to occur when production costs rise, product prices rise, and consumer spending power falls as a result of rising heating, transportation, and other energy expenditures.
How Can We Combat Stagflation?
Combining fiscal and monetary policies can combat stagflation. However, the particular measures enforced depend on the economic school of thought.
Monetarists
Monetarists think that managing the money supply is the primary source of inflation.
A monetarist would respond to this circumstance by reducing the money supply, which reduces spending. As a result, demand falls, and prices fall as well. The fundamental disadvantage of the policy is that it does not encourage growth. Later, a combination of lax monetary policy and taxation would be necessary to address growth.
Supply-Side Economist
One solution is to increase economic supply by reducing waste and increasing production. Energy price controls (if possible), efficiency investments, and production subsidies will all help to cut prices and increase overall supply in the economy. This raises customer purchasing power, increases output, and reduces unemployment.
A Market-Based Strategy
Some economists believe that allowing the market to decide is the best method to tackle stagflation. Consumers’ unwillingness to pay ever-increasing asking prices for goods will eventually result in a price correction. As a result, demand will decrease, and inflation will moderate.
The free market will also assist in reducing unemployment by appropriately allocating labor. However, the plan may not bear fruit for years, if not decades, leaving people in horrible conditions in the meantime. After all, as Keynes once said, “in the long run, we’re all dead.”
How Does Stagflation Affect the Crypto Market?
The specific effects of stagflation on crypto are, at best, unclear. However, if we assume that other market conditions remain constant, we can make certain fundamental assumptions.
Minimal or Negative Growth
Stagnant or declining income levels are the result of an economy that is neither growing nor contracting. Buyers have less disposable income in this scenario. Because ordinary people must spend money on needs like food and housing, the number of people buying Bitcoin may decrease while the number of people selling it increases. When economic growth is sluggish or negative, large investors are less likely to invest in risky assets like stocks and cryptocurrencies.
Government Actions to Combat Stagflation
Typically, a government will strive to reduce inflation before addressing concerns about economic development and joblessness. Raising interest rates is one method of reducing the money supply and combating inflation.
As a result, customers are hoarding their money in banks, limiting liquidity and driving up borrowing costs. When interest rates rise, investments with a high potential payoff also have a higher risk. As a result, if interest rates increase and the money supply reduces, bitcoin demand and price may decrease.
When a government succeeds in bringing inflation under control, it frequently works to stimulate the economy. Quantitative easing and interest rate decreases are common approaches. The crypto market would surely benefit from an increased money supply.
Rise Inflation
Many financiers believe that Bitcoin is a sensible protection against price rises. Keeping your money in fiat currency without earning interest reduces its real value as inflation grows. Some people have turned to Bitcoin as a method for protecting against this risk and even profiting in the long run. Bitcoin is appealing to investors as a store of value due to its supply and demand constraints.
Investors who have owned Bitcoin and other cryptocurrencies for a long time may have profited from this hedging strategy in the past. Especially during or after periods of economic expansion and inflation. However, in shorter periods, particularly during stagflation, it is feasible that using crypto as a hedge against inflation will be ineffective. It’s also worth noting that other variables, like the developing link between cryptocurrencies and financial markets, are at work.
Stagflation During the 1973 Oil Crisis
The Organization of the Petroleum Exporting Countries (OPEC) imposed an oil embargo on a number of countries in 1973. This choice was a retaliation for the public backing of Israel during the Yom Kippur War. Oil prices shot up after a sudden drop in supply, causing shortages in the supply chain and price increases for consumers. As a result, inflation rocketed upward.
In order to promote growth in the economy, central banks in countries like the United States and the United Kingdom have lowered interest rates. Borrowing money costs less and encourages spending rather than saving when interest rates are low. However, increasing interest rates and encouraging customers to save is the standard technique for doing so.
Many Western economies faced high inflation and stagnating economies due to the high cost of oil and energy, which made up a substantial portion of consumer expenditures.
Conclusion
Due to the unusual nature of stagflation, which typically does not involve inflation or negative growth, stagflation poses a challenge for economists and policymakers. Combating stagnation with inflationary instruments is harmful while attempting to rein in inflation with contractionary policies might have the opposite effect. Therefore, in stagflation, it is important to take into account the macroeconomic background and its many components, including money supply, interest rates, supply and demand, and the employment rate.