The American Economy Towards Stagflation?

Abstract

The title of this paper is: “The American Economy Towards Stagflation?” Iain McLeod, Chancellor of the Exchequer in UK in 1965, was the first who formally used the expression stagflation. The word combines “stag” from a stagnating economy and “flation” due to high inflation. In other words stagflation is a recession with the occurrence of high inflation at the same time which was incompatible with traditional macro economy before the 1970`s which suggested that there were a trade-off between the inflation and the unemployment.

What causes stagflation? The most common theory in the teaching books is the cost-push shock. The other theory presented in this paper is inappropriate monetary policy; stop-go-policy. Due to the knowledge about the cost of stop-go-policy from the 1970s and 1980s, it is not likely that the American economy will experience stagflation of the same degree again caused by this kind of policy.

The inappropriate monetary explanations and the cost-push shock theory are not necessarily contradictory to each other, but can be complementary. I believe that it might be the combination of these two theories which could lead the American economy into stagflation. It is expected that the economy will grow beneath trend in the first half of 2008. But if the effects of the stabilization policy actions are sufficient, the economy will pick up again in the second half of 2008 and beginning of 2009, and for the American economy to experience a period of stagflation, the inflation will have to increase the periods in between.

I believe that the largest possibility for a period or several periods of stagflation is if the inflation increases further now and the Fed has to increase the interest rate to target inflation. That will reduce the economic growth and lead to a negative output gap. At the same time the inflation expectations will continue to increase due to persistently high food and energy prices. Whether or not the Fed will succeed in deflating the economy quickly and avoiding a period of stagflation depends on the creditability the private sector has to the Fed.

This paper is divided in three parts, Part A: theory, part B: empirics and part C: discussion. Part A begins with defining the most central measurements for stagflation, furthermore will the Aggregate Supply–Aggregate Demand (AS-AD) model be presented, as it will be used to illustrate both explanations for stagflation.

In part B empirics from the 1970s and present will be presented. The liquidity in the market due to monetary policy and the food and oil prices will be emphasized. The assumption made is that the financial crisis present has driven the American economy into recession.

Part C will discuss the development of inflation. To be able to discuss how likely it is for the American economy to head towards stagflation, increased inflation will be decisive as the assumption about recession is already made. The oil prices are high due to low supply, uncertainty about the future and a weak dollar. The food prices are increasing due to “agflation”. Higher input prices, as food and energy, might with a lag lead to higher prices through the price mark-up. More expensive imports will directly increase the core inflation. The question is will this raise in general commodity goods prices drive the labour to demand higher nominal wages, in order to keep the real wages at a desirable level? Or will the increasing unemployment numbers dampen the wage negotiations?

Is the American economy heading towards stagflation? I do not know. The economy is a living animal lead by psychology and changes daily due to the expectations in the market. All I can do is to wait and see.