Question

Explain stagflation. What causes stagflation and what are examples of occurrences in our economy. Relate this topic to the Phillip’s Curve and demonstrate why this is a problem to traditional Keynesian thought. What would you recommend to the Fed when stagflation comes calling?

Answer 1

Stagflation is a condition of slow economic growth and relatively high unemployment, or economic stagnation, accompanied by rising prices, or inflation. It can also be defined as inflation and a decline in gross domestic product (GDP).

Predominant economic theory at the time could not easily explain how stagflation could occur. Even though some of its causes are

1.Sudden increase in the cost of oil thereby reducing economic productivity.

2. Poorly made economic policy. Harsh regulation of markets, goods and labor in an otherwise inflationary environment are cited as the possible cause of stagflation.

The most specific example of stagflation was the U.S. economy during the 1970's, which experienced persistently rapid inflation and high unemployment.

Phillips Curve claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. However, the original concept has been somewhat disproven empirically due to the occurrence of stagflation in the 1970s, when there were high levels of both inflation and unemployment.

The notion that stagflation in the 1970s falsified Keynesian economics is examined utilizing the methodology of scientific research programs Lakatos (1970). This falsification is found to be unnecessary, as Keynesian economics was able to account for stagflation with the augmented Phillips curve. Moreover, the transition from pre-stagflation Keynesian economics to post-stagflation Keynesian economics entailed genuine scientific progress (as defined within Lakatos's framework). In contrast, new classical economics, which eventually supplanted Keynesian economics as the dominant school of macroeconomic thought, was not able to explain phenomena associated with the Great Depression.

To overcome stagflation we should take following measures

1.Increase aggregate supply (AS) through supply-side policies, for example, privatisation and deregulation to increase efficiency and reduce costs of production.

2.imiting wage increases can break the cycle of wage inflation and help to improve the economic situation. In practising wage control is fairly difficult to implement and had little impact in solving stagflation.