The word stagflation is the combination of two words Stag from stagnation and flation from inflation. In stagflation both the higher level of employment and inflation are attached. It is therefore, also called “Inflationary recession.” According to Keynesian it occurs due to rise in cost of production or fall of supply.  If the supply goes downward it will certainly affect the price level which will go higher, it will also reduce the employment. This may result the stagflation.

Possible causes of stagflation include short supplies of essential commodities (such as oil) and too fast a rise in money supply (which in turn usually reflects government policy). Stagflation occurred in the 70s and 80s. Economic theory prior to that time regarded the combination as unlikely, if not impossible.

Causes of Stagflation

  • Supply Shock
  • Government regulations

Supply shock is a classic example, let us look at it. A supply shock is an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good. This sudden change affects the equilibrium price. As we know supply has inverse relationship with price, so when supply goes down price goes up, causing inflation.

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