Stagflation is an economic condition characterized by the simultaneous occurrence of high inflation, slow or negative economic growth (stagnation), and elevated unemployment. The term combines “stagnation” and “inflation” and was coined in the 1960s to describe a phenomenon that most prevailing economic models at the time held to be nearly impossible under standard assumptions. Because conventional Keynesian demand management theory predicted a trade-off between inflation and unemployment - captured in the Phillips curve - stagflation presented a significant empirical and theoretical challenge to mainstream macroeconomics.
Standard macroeconomic theory, as it developed through the mid-twentieth century, treated inflation and unemployment as inversely related: policymakers could accept higher inflation to reduce unemployment, or tolerate higher unemployment to bring inflation down. Stagflation breaks this assumed relationship. Economists associated with the monetarist school, particularly Milton Friedman and Edmund Phelps, had independently warned before the 1970s that the Phillips curve trade-off was not stable in the long run, and that expectations of inflation would shift the curve. Their predictions were borne out by events, and the episode substantially reshaped economic theory.
The most widely studied instance of stagflation occurred in the United States and other Western economies during the 1970s, driven by a combination of supply-side shocks (particularly the 1973 OPEC oil embargo and the 1979 oil crisis), expansionary monetary policy in the preceding years, and structural factors including wage-price spirals and declining productivity growth. For a detailed account, see Stagflation - History.
Economists identify several mechanisms that can produce stagflation:
The relative weight of these factors is a matter of ongoing debate. See Stagflation - Causes Debate.
Stagflation poses a dilemma for conventional stabilization policy: tools used to fight inflation (tightening monetary policy, reducing government spending) tend to worsen unemployment and slow growth, while tools used to stimulate growth tend to worsen inflation. The U.S. Federal Reserve under Paul Volcker broke the 1970s stagflation through a sharp and sustained increase in interest rates beginning in 1979, which produced a severe recession before inflation fell. The costs and tradeoffs of that approach, and whether alternative policies could have achieved similar results, are addressed in Stagflation - Debate.
There is broad consensus among economists that the original Phillips curve formulation was incomplete, and that inflation expectations play a central role in the relationship between inflation and unemployment. There is substantial agreement that the 1970s stagflation in the United States was driven in significant part by supply shocks and prior monetary expansion. Disagreement persists on the optimal policy response to stagflation, the relative contributions of various causes, and whether stagflation-like conditions can recur in modern monetary regimes. See Stagflation - Economics Consensus.