Stagflation [UPSC Economy Notes]

History of Stagflation

• In 1973, the Organization of Petroleum Exporting Countries (OPEC) decided to cut supply. This sent oil prices soaring across the world.
• The rise in oil prices constrained the productive capacity of most western economies that heavily depended on oil, thus hampering economic growth. This resulted in a decreased output of the industries dependent on these energy resources and thus contributing to a rise in unemployment. On the other hand, the oil price spike also led to inflation and commodities became more costly.
• The net result was lower growth, higher unemployment, and higher price level.

Stagflation Concerns in India

The COVID-19 pandemic and its impact on the Indian economy had raised fears of stagflation in India. The lockdowns during the pandemic resulted in a fall in economic growth and increasing unemployment even as the price of commodities increased due to supply constraints.

• However, some economists have ruled out stagflation in the Indian economy based on the following reasons.
• While the Indian economy contracted during the pandemic years, this would be only a temporary phenomenon and India is expected to grow faster in the coming years.
• Though retail inflation has been quite high, core inflation – that is inflation without taking into account food and fuel – is still benign. The spike in inflation rates is likely to flatten out in the coming months.

Concerns associated with stagflation:

Double pressure:

• With stalled economic growth, unemployment tends to rise and existing incomes do not rise fast enough and yet, people have to contend with rising inflation. So people find themselves pressurised from both sides as their purchasing power is reduced.

Difficulty in countering:

• Stagflation characterized by low economic growth rates and high inflation rates results in an unfavourable combination and can be a dilemma for governments since most actions designed to lower inflation may raise unemployment levels, and policies designed to decrease unemployment may worsen inflation.

Why Stagflation is Bad

• Reduced purchasing power: Stagflation leads to a decrease in purchasing power as prices rise, but incomes do not. This means that individuals and businesses can buy fewer goods and services, which can lead to a decline in their standard of living.
• Higher unemployment: In many cases, stagflation leads to higher unemployment as businesses cut back on production and hiring in response to higher costs of production and decreased demand for their goods and services.
• Economic instability: Stagflation can cause economic instability as businesses struggle to adapt to the changing economic conditions. This can lead to bankruptcies, layoffs, and other negative consequences for individuals and communities.
• Limited policy options: Stagflation can limit the policy options available to governments and central banks. The traditional tools used to combat inflation, such as raising interest rates, can worsen the economic slowdown and increase unemployment. At the same time, policies that are designed to stimulate economic growth, such as increasing government spending or cutting taxes, may further fuel inflation.
• Long-lasting effects: Stagflation can have long-lasting effects on the economy, particularly if it is not addressed promptly. The longer stagflation persists, the more difficult it can be to reverse its effects and restore economic growth and stability.

Possible Steps to avoid Stagflation:

• Targeted monetary policy: Central banks can use targeted monetary policy tools, such as adjusting the money supply or interest rates, to address the specific causes of stagflation. For example, if stagflation is caused by supply-side factors, such as a disruption in the supply of critical resources, a central bank could adjust interest rates to reduce the demand for goods and services.
• Fiscal stimulus: Governments can use fiscal stimulus policies, such as increasing government spending or cutting taxes, to boost economic growth and create jobs. This can help to counteract the negative effects of stagflation.
• Structural reforms: Structural reforms aimed at improving the supply side of the economy, such as investing in infrastructure, education, and skills training, can help to increase productivity and reduce costs. This can lead to increased economic growth and help to reduce stagflation.
• Price controls: Governments can implement price controls to limit the rise in prices for critical goods and services, such as food and fuel. However, this approach can have unintended consequences, such as shortages and reduced quality.
• Wage and price controls: Governments can also use wage and price controls to limit the rise in wages and prices. However, this approach can lead to reduced productivity and supply, as well as increased black market activity.
• Long-term planning: Governments and businesses can engage in long-term planning to prepare for and mitigate the effects of stagflation. This can include investing in new technologies, diversifying supply chains, and developing new products and services.

Conclusion: We are living in a globalised world and hence stagflation presents a dangerous situation before the global economy. It has the potential to provoke political tension and stagnation of  SDG achievement. Hence, it requires global cooperation to avoid this dangerous economic situation. However, as per the RBI report, India is in a better position than many competing economies and is likely to avoid stagflation as the rebound has gathered momentum.

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