Stagflation and the PC Model

Stagflation is a term that describes an economic period whereby inflation and stagnation occur at the same time. Inflationary pressures drive down the price of goods while stagnation results in rising unemployment and a decrease in economic growth. Up until the 1970’s, when stagflation was first witnessed, these two processes were deemed mutually exclusive by macroeconomists. They believed that if high inflation was present restrictive monetary policies by a central bank would reduce its effect. Stagnation on the other hand could be combated through the use of expansionary monetary policy. Clearly the two solutions cannot work in unison leaving Central banks seemingly helpless in the face of mounting stagflation.

There are two main bodies of thought as regards the causes of inflation. We shall now examine them in order to determine the necessary changes we should make to our PC model in order to simulate stagflation in an economy.

The first cause of stagflation is when an economy experiences a severe supply shock. This was precisely what happened in the 1970s when the members of the Organization of Arab Petroleum Exporting Countries (OPEC) ceased supplying oil to the United States, Western Europe and Japan in retaliation for their support of Israel in the 1973 Yon Kippur War. This drastic reduction in the supply of oil caused sharp inflation across these nations as the cost of all goods soared. Central banks enacted excessive monetary stimulus policies to counteract the resulting recession which only further increased inflation. Thus a vicious cycle began whereby a slow-down in the economy was countered with more money being pumped into the market which only further exasperated inflation.

Stagflation can also be caused by inappropriate macroeconomic polices being pursued by central banks. Central banks can cause inflation by permitting excessive growth of the money supply, and the government can cause stagnation by excessive regulation of goods markets and labour markets.

As one will have by now noted, the second cause of stagflation, poor central bank management, was intertwined with the supply shock of the 1970s. However the second cause of stagflation can occur on its own through gross mismanagement of an economy by a central bank and government. Case in point is Zimbabwe where a prosperous and healthy economy was ruined though incompetence, stubbornness and racism. Zimbabwe now suffers from hyperinflation, with some estimates putting annual inflation over 2007 at 100,000%, and “official” unemployment levels of 80%.

Simulating this through the PC model:

By inputting a supply shock to the PC model the central bank will act to prevent a recession. The money supply will be increased though reducing interest rates. However increasing the money supply causes the price level to rise and inflation will accelerate. Rather than contracting the money supply by raising interest rates to prevent inflation from accelerating, the central bank will leave interest rates as they are. This may cause stagflation effects in the economy.

Inflation and employment are typically inversely related to one another. The principal is that high demand for goods drives up prices and companies then hire more employees. Similarly, high unemployment reduces demand. As outlined this relationship is not the case in a stagflation world so the adapted model must first be adjusted for this fact. The assumption should remain however that eventually stagflation will fall off and the initial inverse relationship should return.

As interest rates are now lower this will increase the value of bills, increasing wealth and consumption. However the increase in inflation will counter this nominal increase in household wealth.

The supply shock to the system will take the form of the figure below. Due to the general reduction in supply, prices will increase and output will reduce. As output (Y) falls consumption will decrease.



http://www.answers.com/topic/economics-supply-shock-png-1

In the 1970s stagflation period it was found that workers expectations and demands for higher wages and living standards exceeded the paying capacity of the economy which was already severely limited. Applying these factors to the PC model may also yield us a stagflation effect.

A modeller could also apply some additional fiscal policies to try and simulate stagflation. These could take the form of increasing taxes and reducing government expenditure. The former will increase inflation while the latter will reduce output and growth.

Sources:

Wikipedia; Article Titles: Stagflation, 1973 Oil Crisis, Philips Curve, Economy of Zimbabwe.

Tran, D.T.; A Conflict Model of Stagflation, Eastern Economic Journal; Vol. No. 13; Jan 1987

Godley, W. & Lavoie, M.; Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth; Palgrave Macmillan; 2007