Stagflation and Supply Shocks

Stagflation is a combination that standard demand-driven models struggle to explain: inflation rising while growth stalls and unemployment climbs. It typically happens after a supply shock, something that makes production more expensive across the economy (an oil embargo, a war disrupting a key input, a pandemic snarling supply chains) rather than something that makes people want to buy more.

Why it's hard for policymakers

Ordinary demand-side tools cut both ways here. Raising interest rates to fight the inflation slows growth further; cutting rates to support growth adds more fuel to inflation. There is no single lever that fixes both problems at once, which is what made the 1970s oil-shock episodes so difficult to manage compared to a garden-variety recession.

Worked example

Say an oil exporter cartel cuts output, tripling crude prices. Transportation and manufacturing costs jump economy-wide, so headline inflation rises from 3% to 9%. At the same time, higher input costs squeeze margins, and firms cut production and lay off workers, so GDP growth falls from 3% to -1% and unemployment rises from 4% to 7%. A central bank now faces 9% inflation and rising unemployment simultaneously, hiking rates to tame prices would push unemployment higher still, while cutting rates to support jobs would let inflation run further.