Stagflation
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Stagflation is a term in macroeconomics used to describe a period of characteristic high inflation combined with economic stagnation, unemployment, or economic recession.
Stagflation is thought to occur when there is an adverse shock (a sudden increase, say in the price of oil) in a country's aggregate supply curve. The effects of rising inflation and unemployment is especially hard to counteract for the central bank. The bank has one of two choices to make each with negative outcomes. First, the bank can choose to pursue a loose money policy to stimulate the economy and create jobs by increasing the money supply (by lowering interest rates) and exacerbate the inflation problem further. Or second, pursue a tight money policy (by increasing interest rates) to try and reign in inflation at the cost of perhaps increasing unemployment further.
In the 1960s it was thought that the Phillips curve, which was associated with Keynesian economics suggested that stagflation is impossible because high unemployment lowers demand for goods and services which lowers prices. This results in low or no inflation. However, in the 1970s and 1980s, when presented with actual stagflation, it was realized that the relationship between inflation and employment levels was not a constant, but could be shifted, and that the Phillips relationship was better seen through payroll surveys (Current Employment Statistics) of employment rather than household surveys (Current Population Survey) ([1] (http://www.bls.gov/bls/proghome.htm)).
By contrast, quantity theories of inflation, such as monetarism, argue that inflation is due to the money supply rather than demand and predict that inflation can occur with high unemployment if the government increases the money supply in a period of rising prices.
Stagflation occurred in the economies of the United Kingdom in the 1960s and 1970s and the United States in the Nixon administration of the early 1970s as reported by various news and financial sites. The difficulty in fitting its existence within a Keynesian framework led to a greater acceptance of monetarist theories in the 1970s and 1980s. The pendulum has, to some extent, swung back in the other direction as monetarism had increasing difficulty predicting the demand for money and the long period of low inflation and high employment of the 1990s - a kind of reverse of stagflation.
As of 2004 global stagflation is making a comeback with the price of oil over $40 a barrel, the US government slowly increasing interest rates, and employment rates stagnant. Monetarists and Keynesian economics continue to have difficulty explaining the phenomena.
Supply-side economics emerged as a response to US stagflation in the 1970s. It largely attributed inflation to the ending of the Bretton Woods gold standard in 1971 and the lack of a specific price reference in the subsequent monetary policies (Keynesian and Monetarism). As a response most governments today compile consumer price indexes as part of their monetary policy.
Supply-side economics asserts that the contraction component of stagflation was caused by the inflation induced rise in real tax rates (see bracket creep). In addition certain states in the USA had laws against nominal interest rates being above a certain level and in the midst of inflation this forced real interest rates to be negative. In some places this caused a collapse in finance for business.
The coinage of the term, which is a portmanteau of stagnation and inflation, has been claimed for the UK Chancellor of the Exchequer Iain Macleod who died in 1970.