What is Stagflation?
Saturn Devours His Son
Stagflation is generally described in the principles macroeconomics textbooks as decreasing GDP (and therefore rising unemployment) and increasing price levels (inflation).1 So, stagflation only happens when GDP is falling (unemployment is rising) and inflation is rising? Not so. Let’s dive into the macroeconomic shifts that underly stagflation, and once again explore the overarching theme in Ben’s and my book, Inequality by Design, that “no matter how bad you think it is, it is actually much worse.”
So a couple true/false questions for you.
Tariffs lead to stagflation. True/False?
The Fed through easier monetary policy can cause stagflation. True/False?
Stagflation is caused by the price expectations of producers and firms. True/False?
This is a hard one. The first two are not true. The third is true. The first two are true if the tariffs or the Fed create expectations of increased inflation for producers.
In the Keynesian AS-AD model context, stagflation is a shift in the Short Run Aggregate Supply Curve (SRAS). The SRAS demonstrates the increasing relationship between real GDP growth and inflation. That is to say, if firms observe prices on the market rising, they will in the short run provide more goods and services, leading to a boost in GDP growth. Higher prices, firms produce more. Remember we are not dealing with the Aggregate Demand (AD) curve, or the consumer side of things. In that case higher prices mean lower consumption, and inflation going up leads to real GDP going down. Seem contradictory? Surely, Ryan, you’re lying to me. Well, what I say is true. FROM A CERTAIN POINT OF VIEW.2 On the firm side of the macroeconomy inflation and real GDP have an increasing relationship. From the consumer side it is the opposite. This is why the Keynesian model has a supply and a demand curve.3 But wait there’s more. There is also a long run supply curve (The Long Run Aggregate Supply, or LRAS), which is a straight vertical line, because in the long run real GDP growth is related to the factors of production (labor, capital, technology, institutions) and not prices.
This is where we get our macroeconomic miracle of three curves intersecting at a long run GDP growth and inflation pairing.
Here’s a slide from my previous life as an economics professor:
The three curves intersect at the inflation target (pi tilde), and real potential output target (y tilde). Both of these are equal to zero in this graph, meaning the inflation target of 2% is reached (observed inflation - target inflation = 2% - 2% = 0%), and the real GDP growth target is reached of 1.8% (observed real GDP - target real GDP = 1.8% - 1.8% = 0).
Focus on the SRAS curve.
This is my explanation to students about how short run aggregate production in the economy is related to inflation expectations. Suppose we find ourselves producing in the aggregate along the orange horizontal line. If we are at any point around the orange triangle, prices are rising faster than firms expected. If you’re selling books and find out books are getting a higher price than expected on the market, you as a producer will do what? Make more books as soon as you can! Push out those brilliant drafts as quickly as possible to Upriver Press and strike while the iron is hot. Inflation after all is higher than the target, so these price bumps may not last long. If we are in the green trapezoid-ish-shape (I really need to review geometry), then the books are receiving a lower price than you expected. Maybe don’t send off those drafts as quickly as possible for the editorial team. In fact, slow down a bit. Keep your inventory of drafts stashed away for a later date when prices may increase at a faster rate. None of this is stagflation, contraction, or expansion. This is the short run movements along the curves that are pushed back to the equilibrium in a “short run” (whatever that may mean in macroeconomics).
What then is stagflation that could potentially last in the long run? This.
Producers change their long run expectations. That inflation target is no longer the inflation target. Note this says nothing about fiscal policy (tariffs) or monetary policy (expanding monetary supply). This is based solely on the expectations of producers. The support for this is that Volcker in the early 1980s had to take extreme monetary policy measures to change inflation expectations among all the firms in the US economy. The Fed cannot pull a magic lever and change everyone’s preferences and beliefs (and may whatever eldritch terror running the macroeconomy help us if they ever do). Stagflation is caused by a contraction in short run aggregate supply due to firms expecting higher inflation at all levels of real output growth.4 These expectations could be caused by the belief that OPEC will increase oil prices, and this will have a significant impact on energy, plastics, and other prices. It could be caused by the belief of firms that the central bank will go to extreme measures to maintain the inflation target and then expand back to its old position. It could be caused by the belief that tariffs will raise input prices, and firms then slow production. What is important to stagflation is what producers are expecting, and it may take extreme Volcker style contraction measures from the Fed for firms to stop expecting increased prices due to the new, massive tariffs.5
Now note there is a short run equilibrium here that has formed from the orange line and black line crossing. The economy will tend toward this lower than target real GDP growth rate, and higher than target inflation rate, meaning we will see the tell-tale signs of stagflation.
Note again this model is looking at the output gap and inflation gap, or how far real GDP and inflation are from the desired targets of 1.8% real GDP and 2% inflation. That means hidden stagflation can occur. That means if real GDP is growing at 1.2% and inflation is growing at 3%, we have “stagflation” though certainly not in the extreme 1970s case. But it would exist. Has the US economy been facing hidden stagflation? If so, it would look like a real output gap that is less than 0% (though not a real GDP growth rate that is less than 0%! Just less than 1.8%), and an inflation gap this is higher than 0%. FRED, my beloved data, please give me good news.
Real GDP output gap below 0% means contraction. PCE inflation growth above 0%. Lower than target real GDP. Higher than target inflation.
Godamnit, FRED. You just couldn’t give this one to me.
Keep in mind that there is a method to the madness of these tariffs and the stagflation they cause. It is a massive wealth transfer from the general population of producers and consumers to the government, and their favored industries. MAGA seems to be very anti wealth transfers, unless it benefits wealthiest, and then they are quite alright with the stagflationary result of Saturn devouring his young. Expect inequality to worsen. We may well continue to see decreased output (jobs) and increased prices across the board. The worst part is that the medicine for this cure will be a painful monetary contraction similar to the late 1970s and early 1980s under Volcker. We did not have to go through this.
A note on unemployment: Okay, okay, calm down folks, I can smell you all thinking “actually stagflation is rising unemployment!” Well, it is, and it isn’t. Based on Okun’s Rule, real GDP is strongly correlated to unemployment, but there are jobless recoveries of GDP, and yes there are hidden labor contractions in GDP growth. The slowing or contraction of real GDP is a better measure in general for stagflation because the unemployment rate only measures those “willing and able” to work, that is those actively seeking jobs but not finding them. A stagflation could be hidden with low unemployment if a large enough population just drops out of the labor force, say to join the military, go to school, or perhaps they have just given up on getting a job. FRED? What say you?
So yes. Labor force participation has decreased.
I use my old copy of Krugman and Wells, 3rd Edition, for reference.
Obi Wan Kenobi was a fantastic macroeconomist.
And not because deep down all macroeconomists have “microeconomist envy” and really want to get back to that lovely mathematical world of price and quantity for a single good or service. No, our Cantor has not yet created that paradise for us, from which we will not be expelled.
This intuition is more in line with Cowen and Tabarok’s economics text, and not with Krugman and Wells who use price levels and GDP levels instead of growth rates.
Or we could stop the tariff nonsense and focus on a fiscal policy that doesn’t destroy producers and consumers like Saturn devouring his young.