Stagflation

You just learnt about inflation and how it is important to invest in instruments that earn higher rate of return compared to inflation. Now let’s explore a similar sounding concept called stagflation.

Stagflation is a situation where economy is stagnating, i.e. it is not experiencing any GDP growth and at the same time there is also high inflation. It is a nightmare situation for any country, as high prices kill purchasing power and harm the poor, while low or negative GDP growth worsens the situation by causing unemployment.

Now the basic question is how does a country get into such a mess? There could be many reasons, but the concept of “supply shock” allows us to understand the causes of stagflation the best. Suppose tomorrow all oil producing nations decide to cut supply and suddenly there is shortage of oil everywhere. Obviously the price of oil will start increasing. Oil is the lifeblood of any economy as it is used in various activities like transportation, power generation, manufacturing of goods etc. Thus rising oil price will push up prices of all goods. Consider oranges, to get farm produced oranges to a far off market, there is a huge transportation cost involved which will increase with rising oil prices. Keeping this in mind, let’s look at the following flow chart: