When high inflation accompanies slower economic growth then, it leads to stagflation. Though it is rare to have high inflation and almost stagnant economic growth. It happened in the 1970s. There are mainly two reasons that lead to stagflation.
- When prices and wages don’t adjust with respect to the changes in aggregate demand,
- Changes in aggregate supply.
We start with the first scenario i.e. changes in aggregate demand. Let’s say there is a one-time increase in aggregate demand. Then, it would lead to an increase in output. But, the prices won’t adjust at this point in time. But, in the meantime, it would deplete the inventories. This leads to an increase in the prices of goods and services eventually. Simultaneously, the costs of producing goods and services would also begin to rise. The rise in the price of goods and services along with increasing costs ultimately limits the output. The rise in prices reduces the demand for goods and services whereas increasing costs doesn’t provide the incentive to producers to produce more. Stagflation occurs at the point where output falls and prices are still increasing.
Changes in aggregate supply: The supply of goods and services can be affected due to an adverse event. If the demand for the product is inelastic then it would affect the price of goods and services. The prices would keep rising. Consequently, it affects the demand for the product. And, if the aggregate supply can’t be restored then it eventually would reduce the demand for the product. But, the prices would still stay high as the supply still isn’t there. So, that translates to lower output and higher prices. At first, it may seem that the changes in aggregate supply only affect the producers and consumers of the product. Over time, its impact is much wider than expected.
