TOPIC: STAGFLATION

SUBMITTED TO Ms Tayabba SUBMITTED BY Zonaira Waseem (718) Asma Pervaiz (636) BS(HONS) IV Major Economics Section E

ASSIGNMENT QUESTION
Zonaira Waseem (718)
What is stagflation? What are factors causing inflation?

Asma Pervaiz (636) Briefly discuss the concept of stagflation in the current context of Pakistan.

STAGFLATION
ZONAIRA WASEEM(718)

INTRODUCTION
The Term was First used by Lain Macleod in a speech to the British Parliament in 1965, and since then it has aptly come to describe a situation where the unemployment rate and the inflation rate are constantly rising together. This is the official definition and there really could be no easier way to define it. Stagflation describes a "perfect storm" of economic bad news: high unemployment, slow economic growth and high inflation. The term was born out of the prolonged economic slump of the 1970s when world oil prices rose dramatically, fueling sharp inflation in developed countries., For these countries, including the U.S., stagnation increased the inflationary effects. United States experienced spiking inflation in the face of a shrinking economy, something economists had previously thought to be impossible.

DEFINITION:
According to Barron "STAGFLATION term was coined by economists in the 1970s to describe the unprecedented combination of slow economic growth and high unemployment (stagnation) with rising prices (inflation). In Economic Terms:

Stagflation = Stagnation + Inflation

As the word stagflation is a contraction of
Stagnation Inflation

Stagnation: When the economy is stagnant, it means that the gross domestic product
(GDP) -- the standard measure of a nation's total economic output -- is either growing at a very slow rate or shrinking. Stagnation on the other hand results from low demand, leading low output resulting into collapse. The natural result of economic stagnation is increased unemployment. Businesses lay off employees to save money, which in turn decreases the purchasing power of consumers, which means less consumer spending and even slower economic growth.

Inflation: Inflation is the persistent rise in prices rather than a once-for-all rise in
prices. Inflation is a result of high growth which increases the income and correspondingly increases the demand, thereby leading to hiking of prices. Inflation or Stagnant Economy in itself is a difficult situation for any country. This is why stagflation is so dangerous. Imagine a scenario in which you have both a sinking economy and runaway inflation. With high unemployment, consumers have less money to spend. Add inflation, and the money they do have is worth less and less every day. This is a very unhealthy situation for a country. It's a highly unusual situation because a slow economy reduces demand enough to keep prices from rising. Why? Businesses get into a competitive price war to attract whatever customers remain. Without the ability to raise prices, there usually can be no inflation.

Why STAGFLATION is so Dangerous?

Economic slowdowns are a normal part of the macroeconomic cycle. When financial speculation gets out of hand (as it did with the technology stocks of the late 1990s and the housing market of the mid-2000s), the market needs to stabilize itself. This usually happens through a temporary, if painful, recession. But here's the difference between a recession and stagflation: The prolonged period of slow economic growth is coupled with high rates of inflation. Inflation is the ongoing increase in prices for goods and services, but it can also be described as an ongoing

decrease in the buying power of money. In a normal year, inflation might rise two or three percentage points. If the rate of inflation begins to rise past 5 or even 10 percent, things can get hairy. This is why stagflation is so dangerous. Imagine a scenario in which you have both a sinking economy and runaway inflation. With high unemployment, consumers have less money to spend. Add inflation, and the money they do have is worth less and less every day. If you're on a fixed income, inflation erodes the value of your monthly check. And if you've managed to save some money, inflation eats away at its value, too. Inflation is a real confidence killer in an already depressing economic environment .

STAGFLATION IN 1970S

Prior to the 1970s, economists thought it was impossible to have both a stagnant economy and high inflation. According to the economic principles of John Maynard Keynes, an influential British economist, inflation was a byproduct of economic growth. For Keynesians, it's all about supply and demand. When demand is high -- as it is during a booming economy -- then prices go up. What the Keynesians didn't realize was that there were other powerful economic forces that could throw inflation into an upward spiral. To really understand how stagflation works, you have to take a trip back to the 1970s.

 The word stagflation didn't even exist until the 1970s. From 1958 to 1973, the United States experienced what's known as the "Post-War Boom." Gross annual products in Western nations grew by an average of 5 percent annually, fueling a slow but steady rise in prices (inflation) over the same period. There were six quarters of shrinking Gross Domestic Product (GDP) growth, while inflation tripled in 1973, rising from 3.4% to 9.6%. It remained between 10-12% from February 1974 through April 1975. Unemployment was at 6.1%, a result of the economy contracting for three quarters. why did things go sour in the 1970s? Many experts blame the 1973 oil supply shocks, when OPEC cut its quota and prices quadrupled. This did trigger some oil price inflation. However, it took fiscal and monetary policy combined to create this extreme stagflation. It turns out that the Federal Reserve's monetary policy during the boom years of the late '50s and '60s was unsustainable. The economists at the Fed were diehard Keynesians who believed in something called the Phillips Curve. The Phillips Curve charts the relationship between unemployment and inflation. Historically, when unemployment is low, inflation increases, and when unemployment is high, inflation decreases. It all started with a mild recession in 1970. In the 1960s, the Fed believed that the inverse relationship between unemployment and inflation was stable. The Fed decided to use its monetary policy to increase overall demand for goods and services and keep unemployment low. The only tradeoff, economists believed, would be a safely rising rate of inflation Unfortunately, they got it wrong. The result of unnaturally low unemployment in the 1960s was something called a wage-price spiral. The government poured money into the economy to increase demand, making prices rose. Workers, noting the rise in prices (inflation), expected their wages to rise accordingly. For a while, employers were willing to raise wages, but then inflation began to rise faster than wages. Workers weren't willing to supply labor for lower wages, so unemployment increased even as inflation continued to rise. But the wage-price spiral alone wasn't enough to trigger killer stagflation. The real kicker was the OPEC oil embargo of 1973, which brought oil prices to record new levels. Prices skyrocketed, not only at the gas pump -- where long lines and shortages were common -- but across all U.S. industries. In 1970, inflation was 5.5 percent. By 1974, it was 12.2 percent, and then it peaked at a crippling 13.3 percent in 1979. The stock market ground to a halt. From 1970 to 1979, the S&P 500 returned an average of 5.9 percent annually. But when you subtract for inflation (average 7.4 percent annually), the market lost value every year. The annual return on bonds was 2.6 percentage points lower than inflation.

 President Richard Nixon was running for re-election, and looked for a way to boost growth without triggering inflation. On August 13 1971, Nixon and his aides formulated four economic policies that would succeed in getting Nixon re-elected. Without realizing it, they also sowed the seeds for stagflation. First, Nixon instituted wage and price controls, freezing businesses' ability to raise prices in the U.S. When import prices rose, U.S. businesses couldn't raise prices to remain profitable. Instead, they had to reduce costs. Since they couldn't lower wages, they had to lay off workers. This raised unemployment, reducing demand, and slowing economic growth. Why did import costs rise? This was a result of Nixon's second action -- removing the U.S. from the gold standard, which had kept the dollar's value tied to a fixed amount of gold. Nixon did this to prevent a run on the gold reserves at Fort Knox. Under the Bretton Woods Agreement, most countries pegged the value of their currencies to either the price of gold or the dollar. This turned the dollar into a global currency. As a result, demand for the dollar rose. The crisis was precipitated when Great Britain tried to redeem $3 billion for gold. When Nixon took the U.S. off of the gold standard, the price of gold skyrocketed -from $35 an ounce to $120 an ounce. At the same time, the value of the dollar plummeted. The result? Import prices rose. To fight inflation, the Fed kept raising the Fed funds rate, reaching a peak of 20% in 1979. However, instead of signaling the market and being consistent, the Fed did so in a "stop-go" fashion. This confused businesses, many of whom kept prices high.

CAUSES OF STAGFLATION
Different economists sought to explain the phenomenon of stagflation differently. Three leading views are given below:

Keynesian View:
Keynesian economists blame supply shocks for causing stagflation. They cite surging energy costs or surging food costs, for example, as the cause of economic woes. Monetarists cite overly rapid growth in the money supply for causing too many dollars to chase too few goods. Supply-siders blame high taxes, excessive regulation of businesses and a persistent welfare state that enables people to live well without working.The Keynesians explain the phenomenon of stagflation in terms of upward shift in Phillips curve. This upward shift in the Phillips curve is caused mainly by various cost-push factors, such as Increase in the world prices of crude oil;

 Wage increases due to strong trade unions; Wage increases due to higher cost of living during inflationary period; Changes in the composition of demand for labour in the dynamic conditions, causing an upward shift in wages; etc.

Supply-side View:
Supply-side economists hold the view that various government actions and regulations, which raise cost of production and restrict aggregate supply of goods and services, are responsible for the phenomenon of stagflation. Higher tax rates, minimum wage legislation, social security measures are some such actions. A higher marginal tax rate for example, induces workers to work less. The underlying assumption it that the individuals while acting as workers, savers and investors always respond to the changes on the margin. When the marginal tax rate is raised, it reduces the after-tax pay of the workers, after-tax interest earnings of the savers, and after-tax return of the investors. All this will reduce work effort, saving and investment, which, in turn, reduce output and employment, and increase prices.

Monetarist View:
According to the monetarists, the phenomenon of stagflation is the result of changes in inflationary expectations. The monetarist view has been explained in the FriedmanPhelps model. The Friedman-Phelps model states that an expansionary monetary policy can increase employment at the cost of inflation only if the workers do not correctly anticipate the inflation rate. Such a policy to reduce employment is doomed to be a failure.

 It will appear successful only in the short period as long as the government is able to fool labour by maintaining an actual inflation rate greater than that expected by labour. In the long run, when the labour will correctly anticipate the higher rate of inflation, the unemployment rate will return to its natural level. Thus, in the long period, the expansionary monetary policy will lead to an increase in both the price level and the unemployment rate. The phenomenon of stagflation is of comparatively recent origin. It depicts a situation in which prices are sticky and refuse to fall even in the face of poor demand. In other words, it is a combination of stagnation in demand and persistent high prices.Stagflation arises when there are rigidities in the economic system and production costs, supply flows, demand, and prices do not adjust to each other, and in which, therefore, prices refuse to come down.

Let us look at some other possible causes for this phenomenon.

The presence of indirect taxation is an important cause for persistent high cost-price structure of an economy. This is more so when; The taxed goods have low elasticity of demand, Taxation is not confined to final consumption goods but is levied on intermediate goods and other inputs, and Taxation is not of pure value-added tax variety, but is a multi-point cumulative variety in which taxes have to be paid even on taxes paid earlier. Wages and prices of essential inputs maybe high and protected by law, so that it is not possible to lower cost of production. The problem becomes further intractable if employment of labor is protected together with the emoluments and if there are restrictions relating to the type of technology to be used. Policies pursued by the government may be such that productivity and production are not encouraged. This may be done through various restrictions like licenses and permits, etc. Dependence upon official sources of supply involving delays and high costs will also contribute to this outcome A country may be critically dependent upon some essential but costly imports like petroleum products.

 The producers may be able to adopt oligopolistic and other collusive practices. Stagflation also persists if government policy allows the producers to enjoy "sheltered market" (that is, they can sell in the domestic market without facing foreign competition). In that case, the sellers do not have an incentive to reduce costs and prices. There can also be some technical and institutional rigidities which prevent a reduction in costs-and prices even when demand is not strong. Still others theorists argue that stagflation is simply a natural part of the business cycle in modern economies or that politics or social structures are to blame. The failure to forecast, avoid, and contain stagflation as it appears and disappears in various parts of the global economy suggest that the true answer may not yet be known. The second explanation offered by economists as to why stagflation occurs is simply bad economic policy. For example, allowing too fast of a growth in the money supply or over regulation of markets. Each of these factors lead to a dramatic rise in costs and prices and lead to a loss of jobs.

Effects of Stagflation
Some effects of stagflation are unemployment, rising prices in all goods, all with a very slow recovery process. Stagflation may also lead to volatility and lack of confidence in markets, leading to even more reactionary maneuvers by central banks, such as changing interest and exchange rates.

How is Stagflation Corrected?

According to Keynesian theory, inflation and economic stagnation cannot happen simultaneously. Using monetary policy to control one factor, say inflation, can lead to further economic woes. Countries around the world have tried different methods to tackle stagflation. Based on such experiences, it is seen that there is usually a time lag before an economy turns around. The intervening period is marked with increased business bankruptcies and hardship to the public at large.

 Policymakers use a combination of fiscal and monetary policies to control stagflation. While increased spending by the government or reduced taxes stimulate growth, monetary policies are used to manage liquidity in the system and to control inflation. Governments also aim to stabilize key institutions so as to retain public confidence in their operations. Measures to reduce costs, such as more efficient design of processes and machinery as well as alternative technologies and conservation of resources can also contribute favorably to reverse stagflation.

How Do We Respond to Stagflation?

Stagflation leads to a drop in consumer confidence and uncertainty about how long this condition would last. Our best response as consumers is to make wiser decisions about budgeting and investing. Financial experts advice us to maintain an emergency fund of 3-6 months of living expenses at all times. This advice is even more relevant in a slow economy. Even if funds are available, consider carefully before purchasing high value items or a second home. Stagflation increases the risk of job loss. So use every opportunity to sharpen job skills. Ensure that credit card or other high-interest bearing debt is under control. Paying down credit cards and maintaining about two cards is a wise move. In summary, stagflation is caused by macroeconomic events that are not within our control. The interim period before the situation is corrected can call for sacrifices on the part of consumers. Careful planning in both spending and investing can help us see through such downturns.

STAGFLATION IN PAKISTAN
ASMA PERVAIZ(636)

Stagflation refers to a combination of two of the major economic conditions:

The overall economy slows down (stagnation); and Prices climb sharply (inflation). lets say from 01 July 2010 to 30 June, 2011 (called Fiscal Year 11 or 2010-11) as is the case in Pakistan. Inflation is the rate at which general level of prices of goods and services in an economy rise over a period of time. It is expected that profits earned are redirected to generate more economic activity. This way a controlled rise in inflation should ideally lead a country towards economic growth, whereas in Pakistan this is simply not the case. This is due to economic mismanagement of highest order. during the period FY-81 to FY-89 there was a high economic growth with low inflation; during the period FY-90 to FY-01 there was a moderate growth with high to moderate inflation and during the period FY-01 to FY-11 the gap between economic growth and

inflation rise drastically leading towards a state which is referred to as stagflation as indicated above. There can be two over-simplified reasons attributed as the root causes for stagflation. Firstly, increase in oil prices. oil is used as an input to generate economic activity i.e., electricity is produced with oil (thermal power generation) and oil is also used by transport vehicles. Since Pakistan imports a great deal of oil from abroad so naturallywhen the international prices of oil and other petroleum commodities go up it automatically results in inflation. Secondly, when the government decides to print money it also leads to inflation.In simple words when cost of carrying commercial activity goes up the economy slows down due to which stagflation occurs. In recent times, the Government of Pakistan has on several occasions borrowed money from the State Bank of Pakistan and relied on printing currency which is the main cause for hyper inflation in the country. In recent times, the Government of Pakistan has on several occasions borrowed money from the State Bank of Pakistan and relied on printing currency which is the main cause for hyper inflation in the country. Stagflation is a double edged sword for the poor (have-nots) employment opportunities vanish and at the same time prices of basic commodities go up. Also the gap between haves and have-nots has increased recently to an alarming level in the country. Particularly Pakistans middle-class, which is considered a backbone of any country, is hit by the ongoing stagflation adversely.

How to overcome the situation:

Economy of Pakistan is in serious situation. It also reflects the ignorance with people concerned with economic planning, financial management and monetary system. Fiscal and monetary systems are two key components in formulating a precise, required economic policy and management relates to take suitable steps in time and this is carried by proper monitoring in place. It is difficult to deal with stagflation when it occurs. However, if the Government is sincere it should cut-down its non-developmental budget and decrease reliance on money borrowing then we can have a chance to cope with the prevailing situation. we have a tendency of over-simplifying economic phenomena and that our economy has evolved into a force which can survive even a deeper turmoil.

Conclusion
In the end an economy suffering from stagflation has a hard time recovering. Normally to curb inflation, the Federal Reserve raises interest rates, however this affects unemployment. And to combat high unemployment, interest rates are generally cut, but this leads to inflation. Basically, the government has little power to achieve the right balance to combat both economic crises at the same.

REFERENCES
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www.forbes.com/sites/moneybuilder/2012/.../stagflation-with-atwist/ notesforpakistan.blogspot.com/2009/08/stagflation.html www.khanacademy.org/finance-economics/core-finance/.../stagflation www.pakistaniaat.net/.../stagflation-in-pakistan-concepts-demystified www.preservearticles.com/.../what-are-the-causes-of-stagflation.html www.ask.com/questions-about/Causes-of-Stagflation www.pugetsoundliberals.org/commentary/Stagflation.htm liamchingliu.wordpress.com/2011/05/02/causes-of-stagflation/ www.investopedia.com/articles/economics/08/stagflation.asp www.preservearticles.com/.../what-are-the-causes-of-stagflation.html http://www.investopedia.com/articles/economics/08/stagflation.asp axzz1xl3HnDy7 http://bgpappa.hubpages.com/hub/An-Overview-of-Stagflation http://www.brighthub.com/money/personal-finance/articles/48951.aspx http://www.ehow.com/info_8444410_causes-effects-stagflation.html dailynews.net.pk/nov2011/26-11-2011/serious.asp www.pakistaniaat.net/.../stagflation-in-pakistan-concepts-demystified/