Stagflation

This post covers the basic concept of stagflation. We will also explain other terms related to inflation and GDP.

GDP is the value of all goods and services produced over a period of time.GDP is a "flow" measure, and a healthy economy will have a nice flow of products and services

Nominal GDP is the value of goods and services measured at current prices. Think of it this way: take a basket of goods and calculate the total value using today's prices. If the current year is 2020, you use 2020 prices.

Real GDP is the value of goods and services measured at base year prices. Take the same basket of goods, but this time calculate the total value using the prices from a base year, such as 2019.

GDP deflator = Nominal GDP / Real GDP = Value of goods and services at current year prices / Value of goods and services at base year prices.

If the GDP deflator is less than one, it means Real GDP is greater than Nominal GDP. This is called Deflation. If the GDP deflator is greater than one, it means Real GDP is less than Nominal GDP. This is called Inflation. These two concepts are fairly easy to understand using the GDP deflator.

Now let us look at this from the perspective of the inflation rate.

Inflation rate is a defined as percentage change in price index

A sustained increase in the inflation rate is called Inflation. A continuous decrease in the inflation rate is called Deflation. From this, we can see that Inflation and GDP are positively correlated. Deflation involves negative inflation rates.

Let us also cover two more concepts related to inflation rates before we get into stagflation.

Hyperinflation: This is an extreme increase in the inflation rate. Think of increases like 400%, 500%, or even 1000%. Hyperinflation is a very bad situation for any country's economy. To put it in perspective, the US Federal Reserve targets an inflation rate of just 2%.

What is Disinflation? Disinflation is a temporary decline in the inflation rate. For example, the rate might drop from 9% to 7% for a short period. However, even after disinflation, the inflation rate stays positive. To sum up, Deflation is much worse than Disinflation. Now when you see these terms in financial articles, you should have a good sense of what they mean.

Now let us get into stagflation. Stagflation is a tricky situation where GDP growth stays flat, but prices keep rising. This seems to go against what we said earlier -- that GDP and inflation are positively correlated.

Iain Macleod, a British politician, is credited with coining the term "stagflation" in 1965.

"We now have the worst of both worlds — not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of 'stagflation' situation. And history, in modern terms, is indeed being made."-Iain Macleod

Stagflation is a perfect storm. It combines low or no GDP growth with high inflation and high unemployment.

A country's central bank typically uses contractionary policies to fight inflation. It uses expansionary policies to reduce unemployment. In a stagflation scenario, the central bank must carefully balance both challenges at once.

Look at the years 1973 to 1975 in the graph above. This period in the US economy shows stagflation. GDP dropped while both inflation and unemployment increased.

There is often speculation in the markets about whether a country is entering or currently in stagflation. For example, as of this writing, some analysts speculate that China may be heading into stagflation. Its inflation rate has been rising while GDP growth has been declining or staying flat.