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Economics teaches that faster economic growth leads to higher inflation and slower economic growth leads to lower inflation. In the 1970s, United States suffered high inflation and slow economic growth at the same time. This contradicts economic common sense.

What were the factors that led to stagflation in the United States during the 1970s?

Wikipedia's answer is a bit daunting; is it possible to provide a succinct answer?

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2 Answers 2

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I don't disagree with @T.E.D's answer, but I think there is an alternative explanation that is a bit more succinct.

The short answer that my econ profs gave is that although in theory wages can be treated as a good (the price rises when in short supply, and falls when in surplus), wages are "sticky downward" - there are legal and practical reasons why the price of labor does not fall. Stagflation occurs when the economy wants to shrink, but the price of labor cannot fall. In the 70's there was a continuous upward pressure on the price of labor, driven by cost of living agreements and unions. This continuous upward pressure created inflation. A variety of forces that are too complex and contentious to analyze succinctly imposed a downward pressure on productivity and economic growth. Stagflation was the economy's attempt to balance these two.

I also wanted to touch on the conclusion that we can ever run out of commodities; we can't. Take, as an example, energy. At the moment the premiere energy commodity is oil. As the world stock of oil depletes, the price will rise. When the price rises high enough (and when governments stop subsidizing cheap oil), the economy will substitute another energy commodity. Prior to 1800, the dominant energy commodity was either wood or human labor; then we switched to whale oil. As the price of whale oil rose, we switched to coal. Then when we discovered how to use oil, we switched to oil. I can't predict what we'll switch to next. While we may run out of a specific commodity, we'll never run out of "commodities" - at least as long as the government doesn't interfere.

Aside: Professor M. Salemi in his course "Money and Banking: What everyone should know" is rather adamant that no change in the price of a commodity can affect inflation. The course is available through the Great Courses series and from audible. I'm only partway through, but the portion I've consumed is clear and simple.

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That middle paragraph is an important point. I can remember as a kid in the early 80's when folks were talking a bunch of scare about us running out of oil in 10 or 20 years. We had an Oil industry guy come to my school for some equal time. He made this same argument. He even said that if it got rare enough and thus the price got high enough, eventually the economics would make it worth dragging oil from the huge amount of shale we have, or switching to alternate fuels entirely. He was the only person I heard make that argument at the time, but history appears to have proven him right. –  T.E.D. Dec 11 '13 at 19:58
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I think it's worth mentioning the Phillips curve, the observed short-term inverse correlation between inflation and unemployment. Prior to the 1970's this was mistakenly thought by many leading economists to be a long-term causal relationship, that states could decrease inflation by increasing unemployment and vice versa. The experience of stagflation showed that this was false, as the labor market simply compensated by adopting wage increases in line with expected inflation, which caused unemployment to go back up. –  congusbongus Dec 11 '13 at 23:28

It neither contradicts commons sense, nor basic economics.

In classic (micro) economics, every good can be represented by two curves: A supply curve and a demand curve, plotted against price for the good and amount sold. The point where the two curves intersect defines the natural market price for that good.

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Now if some external event comes along to make that product more desirable (say there's a snowstorm coming, and you are selling snowshovels), what will happen is the whole demand curve shifts to the right. We say "demand has increased". This causes a shift of the intersection, such that more of the product gets sold at a higher price. There's a positive relation between prices and sales in this case.

Now, all else being equal, this will generally happen slowly across an entire economy if its population is growing. Thus (in the USA at least) we typically expect to see a positive relation between inflation (prices) and economic growth and employment (amount of goods being made and sold). If there's some kind of hiccup (eg: a recession), they will hiccup together.

However, if something instead comes along to make a product harder to supply, what will instead happen is that the supply line shifts back to the left. This causes a new intersection to occur at a higher price and a lower supply. When the supply side is impacted, the relation between prices and supply is inverse.

What happened during the 70's was that the supply of oil dropped drasticly. Since oil (in the form of transportation costs) is an input into practically every good sold, the supply curve of nearly every product was impacted. This caused both higher prices (inflation) and a lower production of goods (slow or no growth, unemployment, etc).

The effects weren't pleasant to live through (unless you were an oil producer), but nothing particularly mysterious was going on.

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Thanks. Your answer is short and sharp. The frightening conclusion is that when the world runs out of commodities, we will die of stagflation. –  curious Dec 11 '13 at 14:45
    
@curious - I suppose. You could also chose to be happy that future interplanetary economies will produce the opposite effect. To do either is to get into the realm of Science Fiction though. –  T.E.D. Dec 11 '13 at 15:33
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I'm not sure that conclusion is supportable; we switched from whale oil to coal to oil to natural gas with minimal disruption. When I get time I'll post an alternate. (NOTE: I'm not disagreeing with T.E.D or curious; just a different perspective on a difficult question). –  Mark C. Wallace Dec 11 '13 at 15:44
    
Also, I'd kind of be cheating if I didn't mention that in classical Keynsian Econ, they didn't really have the concept of the supply curve moving (or even being a curve at all). It seems obvious now, but it was the 70's supply shocks that really cemented this feature of Economics theory. So it was in fact at the time as much of a mystery to a lot of economists as it apparently was to you. –  T.E.D. Dec 11 '13 at 15:45

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