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Tim McMahon Updated April 17,2008
The simple definition of Stagflation is a "stagnant economy
coupled with price inflation". Thus the term Stag-flation.
In other words, prices are going up while the economy is
going down. The word was coined during the inflationary
period of the 1970's.
Under normal conditions one would expect inflation to
heat up the economy. That is one reason the FED generally
increases interest rates during periods of higher inflation.
This helps to cool the economy and prevent inflation from
spiraling out of control.
Of course ,if you have read other articles on this site, you
will know that the primary cause of inflation is an
increase in the money supply.
So clamping down on interest rates is kind of like stomping
on the accelerator with one foot (increasing the money supply)
and stomping on the brakes with the other (increasing interest
rates).
The net effect is not good for your car. In the same way it
doesn't help the economy either. But we digress.
Remember, under normal circumstances increasing inflation
equals an increasing economy as all that new money begins
flowing around.
But in the 1970's we saw something unusual, inflation and a
recession at the same time. This was so unusual that they
coined a new term "stagflation" to describe the situation.
Basically, what happened was that there was plenty of
liquidity in the system and people were spending money as
quickly as they got it because prices were going up quickly.
But the rapid price increases in the price of oil caused many
businesses to become unprofitable, so they began laying off
workers. This threw the economy into a tailspin as
unemployment grew in spite of an increase in the money supply.
The end result was price inflation and high unemployment and
a disastrous economy. Finally, the FED cut the money supply, oil
prices moderated, and the economy was able to get back on it's
feet.
The major problem with stagflation is that the normal
methods of increasing interest rates doesn't help the situation.
The only reason it helps in times of high economic
activity is because it slows the "velocity of money" or the
speed at which it changes hands.
In contrast, when the economy is weak the standard medicine
administered by the FED is to lower interest rates to stimulate
the economy. Unfortunately, it is impossible to stimulate
the economy by lowering rates while simultaneously fighting
inflation by raising rates.
So there is the catch. What do you do? Well at this
point the Government is forced to face the real problem (which
isn't interest rates but the money supply). It has to
reduce the money supply and get the economy back on a firm
footing. That is what finally happened in the early 1980's and
that is what needs to be done now.
The current situation is a result of years of inflation
because low foreign wages and high demand for US paper debt,
were able to keep a cap on our inflation. But finally
higher oil prices are igniting the old fires of inflation while
the sub-prime mess is unraveling the economy placing us in much
the same situation as in the 1970s.
Unfortunately, currently the FED is still in denial and is
trying to lower interest rates and increase the money supply to
fight the stalling economy and it isn't doing very well.
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