2 min read.Updated: 19 Nov 2019, 07:07 AM ISTPuja Mehra
Manmohan Singh has cautioned that while India is not yet in stagflation territory, it would be prudent to watch out for increased risks of such an event occurring
Former prime minister and economist Manmohan Singh has cautioned that while India is not yet in stagflation territory, it would be prudent to watch out for increased risks of such an event occurring. Mint explains the phenomenon of stagflation:
A combination of simultaneously rising inflation and unemployment is called stagflation. The term was coined by Paul Samuelson, the first American to win the Nobel Prize in economics, to describe the simultaneously rising inflation and unemployment rates in the US in the 1970s and 80s. During 1973, the US inflation rate more than doubled, reaching 8.7% in December. It climbed to 14% by 1980. Through this period of soaring inflation, unemployment remained stubbornly high, just as Chicago economist Milton Friedman, who received the Nobel in economics in 1976, had warned of.
What causes stagflation?
Among the most analysed episodes of stagflation is the one in the US that began in 1974 and ended in the early 80s. It was set off by a series of supply shocks, led by surging oil prices, and an excessively expansionary monetary policy, especially in 1972-73, which allowed expectations of inflation to become entrenched. This led to a breakdown of the inverse relationship between inflation and unemployment, as suggested by the Phillips Curve. The appearance of stagflation proved Friedman’s prediction that over the long run there is no trade-off between inflation and unemployment.
What is former prime minister warning of?
Describing the economy as one that is perched in a precarious state, Singh noted that incomes are not growing, household consumption is slowing, and people are dipping into their savings, while food inflation has risen sharply. The risk of stagflation will set in only if inflation becomes uncontrollable. It is very hard for large economies to recover from it.
Real GDP goes up with higher demand. Firms employ more workers and unemployment falls. As the economy gets closer to full capacity, inflationary pressures go up. But with lower unemployment, workers can still demand higher wages, causing wage inflation. Firms can still raise prices as demand is strong. In this situation, unemployment falls, but inflation increases. LSE professor Alban Phillips explained this relationship with the Philips Curve, suggesting policymakers can’t target both low inflation and low unemployment.
Why is stagflation counter-intuitive?
The stagflation of 1970s in the US and the UK led many economists to say that the Phillips Curve had broken down. Friedman and Ed Phelps said the Phillips Curve trade-off only existed in the short run due to ‘money illusion’, where workers are slow to anticipate the inflation in the next year. In the long run, expectations are adjusted, and there is no trade-off. After the 2008 crisis, US unemployment fell from 10% to 4.4%, while inflation was 1-2%.