Stagflation

Stagflation is a situation in which prices rise persistently while economic activity remains weak and unemployment is high. It combines inflation with economic stagnation, meaning slow or stagnant output growth rather than necessarily an outright fall in output.

The combination of macroeconomic conditions

The defining combination is high inflation, weak economic growth and high unemployment. Unlike a normal expansion, rising prices are not accompanied by strong growth in production and employment.

• Inflation means a sustained increase in the general price level, not merely a rise in the price of one commodity.
• Stagnation means that real output grows slowly or fails to grow; stagflation does not require negative growth.
• High unemployment reflects weak demand for labour and inadequate job creation.

How stagflation can arise

An adverse supply shock can raise production costs while reducing the quantity of goods and services firms can profitably produce. This creates cost-push inflation alongside weaker output and employment.

• A sharp increase in energy costs can raise transport and manufacturing costs across the economy.
• Supply disruptions can restrict production and increase prices even when aggregate demand is not growing strongly.
• Not every supply shock produces sustained stagflation; its effects depend on its severity, persistence and the economy's response.

Why it creates a policy dilemma

Stagflation complicates stabilisation because policies aimed at one problem can worsen the other. Demand restraint can reduce inflationary pressure but further weaken output and employment, while demand stimulus can support activity but add to price pressures.

• Higher interest rates can restrain spending, but they cannot directly remove shortages of essential inputs.
• Measures that ease supply bottlenecks and improve productive capacity can help address the underlying supply constraint.
• The policy challenge is to contain inflation without unnecessarily deepening economic stagnation.