Stagflation - AlwaysWealthy


Stagflation is an economic phenomenon marked by high inflation and simultaneous high unemployment and stagnating economic growth. The term first came up in the 1960s to describe a novel phenomenon that Keynesian economists couldn’t explain at the time.

Inflation is thought to stimulate economic growth and lower unemployment. When slow economic growth, high unemployment and rising consumer prices all occurred at the same time, this led many economists to believe that Keynes’ General Theory of Employment, Interest and Money was invalidated or needed reinterpretation.

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Classical Theory of Full Employment

According to economists like Pigou, prices of all goods and services are in an equilibrium when demand and supply are equal.

When there is unemployment, it means there is a surplus or oversupply of labor. In a free market, wages would fall until the price of labor is low enough for existing demand to clear the supply of labor.

At this point, supply and demand would be back in equilibrium, leading to full employment. This illustrates that classical economists view full employment as the natural state of a free market.

The reason why there is unemployment, according to classical economists, is due to the rigidity of wages. This rigidity is the result of interference in the working of the free market in the form of unions and minimum wages. In this sense, minimum wages prevent wages to adjust downward during times of economic downturn.

Keynesian Employment Theory

Unlike classical economists, Keynes did not believe that free markets are self-regulating. He argued that during an economic downturn, consumption and investment would continue dropping.[1] Keynes, John Maynard: The General Theory of Employment, Interest and Money (2009)

The market itself isn’t able to “cure” itself from a recession or depression. Full employment through means of equilibrium, as described by classical laissez-faire economists, isn’t possible.

Instead, governments need to step in to stimulate the economy with fiscal and monetary stimulus. According to Keynesian economics, economic contraction and high unemployment are the result of a lack of money supply. This then leads to deflation.[2] Keynes, John Maynard: The General Theory of Employment, Interest and Money (2009)

In order to counteract economic downturns and reach full employment, governments need to increase the money supply and spend more to avoid a self-perpetuating deflationary spiral.

As a result, Keynes believed that inflation would lead to full employment. This level of inflation, which comes from achieving full employment, is healthy and wanted. Any inflation beyond the stage of full-employment is damaging to the economy.

Policy Makers

Keynesian economics became popular after the Great Depression. Keynes believed that the Great Depression proved that markets don’t self-regulate.

Only by going off the gold standard and increasing the money supply and government spending could governments end the Great Depression. Most central bankers and politicians adopted Keynesianism as foundation of their monetary and fiscal policy.

Whenever the economy contracts and unemployment rises, central banks and governments engage in counter-cyclical Keynesian interventions.

Or in other words, when the economy contracts, central banks pump money into the economy until the labor market approaches full employment. If the economy runs too hot, full employment is present and inflation continues to rise, central banks can loosen their monetary policy.

This balance act between full employment and keeping inflation in check is the Federal Reserve’s dual mandate.[3] Federal Reserve Bank of Chicago. “The Federal Reserve’s Dual Mandate“. Accessed June 1, 2022.


In line with Keynesian economic theory, the Federal Reserve engaged in expansionary monetary policy after World War II ended. At the time economists thought that central banks could let inflation run without any problems to keep unemployment rates low.[4] Federal Reserve History. “The Great Inflation“. Accessed June 3, 2022.

This loose monetary policy, along with the need to finance the Vietnam war, led to a sharp increase in the money supply of US dollars.

During the late 1960s, inflation spiraled out of control. The period between 1965 and 1982 became known as the Great Inflation.[5] Federal Reserve History. “The Great Inflation“. Accessed June 3, 2022. Embedded in the Great Inflation was a period of stagflation.

Stagflation of the 1970s

Right in the midst of the Great Inflation, central bankers, politicians and economists had to face a new and uncomfortable truth.

Economic growth was slow and unemployment high despite raging levels of inflation. Consumer price inflation reached over 14.5% in 1980.[6] Federal Reserve Bank of St. Louis “Consumer Price Index for All Urban Consumers: All Items in U.S. City Average“. Accessed June 3, 2022. Despite this, economic growth was stagnant and unemployment high.

In 1973, the Arab oil embargo put pressure on the US economy. In order to deal with the effects of the energy crisis, the Federal Reserve further increased the money supply, underestimating the inflationary effects of its policies.

Before the Great Inflation, in 1964, inflation was 1% and unemployment 5%. Ten years later, in 1974, inflation was over 12% and unemployment at 7%. And in 1980, inflation was almost 14.5% and unemployment 7.5%.[7] Federal Reserve History. “The Great Inflation“. Accessed June 3, 2022.

Rethinking Keynesianism

This paradox of rising inflation and rising unemployment became known as “stagflation”. It’s a mix of economic stagnation and inflation.

The stagflation in the 1970s invalidated the Keynesian theory that inflation and unemployment have an inverse correlation.

Stagflation showed that inflation can indeed become a problem and get out of control before reaching full employment. This forced Keynesian economists to rethink the relationship between inflation and employment.

External Shocks

Since the period of stagflation followed the Arab oil embargo, some Keynesian economists blamed the stagflation on external shocks, such as the sharp increase in oil prices.

Those that were more critical of Keynesian policy pointed to the Nixon Shock as possible cause for the stagflation. In 1971, president Nixon put tariffs on imports, froze wages and prices for several months and closed the gold window.[8] The American Presidency Project: “Address to the Nation Outlining a New Economic Policy: “The Challenge of Peace.”” Accessed June 3, 2022.

This series of policies, known as the Nixon Shock, severed all ties to gold. It resulted in a truly flexible money supply. The US government didn’t have to back the circulating dollar supply with gold anymore.

This rendered all currencies, including the US dollar, fiat currencies. All checks and balances regarding the creation of new money were removed.

Milton Friedman and Stagflation

Milton Friedman, who claimed that inflation is always and everywhere a monetary phenomenon,[9] Friedman, Milton: The Counter-Revolution in Monetary Theory (1970) explained the Great Inflation and period of stagflation in a different way than Keynes.

According to Friedman, inflation is always preceded by an expansion of the money supply. He also refuted the Keynesian doctrine that inflation leads to full employment.

Friedman argued that Keynesian economists in general ignored the role of money in economics. He viewed the Great Depression primarily as a monetary phenomenon rather than a demand-driven phenomenon.

How to Beat Stagflation?

In the early 1980s, Fed chairman Paul Volcker raised the federal funds rate to almost 20% in an attempt to fight inflation.[10] Federal Reserve Bank of St. Louis “Federal Funds Effective Rate“. Accessed June 3, 2022.

Stagflation and Paul Volcker
Paul Volcker by Edmond J. Safra Center for Ethics

Since then, the Federal Reserve realized that keeping inflation under control is essential, even if it meant temporarily accepting a higher rate of unemployment or slowed economic growth.

After the stagflation of the 1970s, the Federal Reserve changed its macroeconomic outlook and policy. Instead of taking high inflation into account to achieve full employment no matter the consequences, the Fed aims for a consistent mild inflation target of 2%.

Whether and how stagflation can be fought is still disputed among economists. But the mere evidence that inflation and unemployment aren’t inversely correlated led many Keynesian economists to reinterpret inflation and policy makers to reassess their policies.

Despite this contradiction in Keynesian economic theory, most other aspects of counter-cyclical Keynesian intervention are still believed to be valid by most mainstream economists.

However, stagflation ended the dominance of the Keynesian theory and gave room to alternative theories like Monetarism, which Milton Friedman was a proponent of.

Some saw the stagflation of the 1970s as confirmation of Friedman’s hypothesis, giving money a more important role in economic and macroeconomic theory.

Stagflation of 2022

In response to the Covid-19 pandemic, the Federal Reserve and US government engaged in unprecedented monetary and fiscal policy.

The Fed engaged in quantitative easing and lowered the federal funds rate to 0%.[11] Federal Reserve Bank of St. Louis “Federal Funds Effective Rate“. Accessed June 3, 2022. This, along with the government’s fiscal stimulus, is in line with traditional Keynesian counter-cyclical intervention.

But similar to the monetary expansion that led to the Great Inflation, the interventions between 2020-2021 were followed by inflation reaching a 40-year high.

End of 2021, inflation was over 7%.[12] Federal Reserve Bank of St. Louis “Consumer Price Index for All Urban Consumers: All Items in U.S. City Average“. Accessed June 3, 2022. It hadn’t been this high since the 1980s, when Paul Volcker raised the federal funds rate to almost 20%.

As a result, the Fed began raising the federal funds rate and quantitative tightening to get inflation under control. But it did so much less aggressively than Paul Volcker did.

War and Supply Shocks

Beginning of 2022, Russia invaded Ukraine. This triggered an additional external price shock, leading to higher oil prices.

As the Fed tightened its monetary policy, the stock market began selling off and some economists expected a recession.

Persistent high inflation during a recession would be a classical example of stagflation. This led some economists and analysts to believe that the United States is heading for another period of stagflation in 2022.

The conditions are similar, although not equal, to the 1970s. Similarities include the historically high inflation rates following a period of expansionary monetary and fiscal policy.

And like in the 1970s, the price of oil increased significantly due to external factors. At the same time, the government debt of the United States s much higher than it was back then. This makes the period of heightened inflation, and possibly stagflation, unique and different.

While the Federal Reserve has learned from its policy mischief during the Great Inflation and stagflation of the 1970s, the high inflation numbers are once again uncharted waters to navigate for the Federal Reserve.


June 3, 2022