Stagflation occurs where there is a combination of rising prices (inflation) and stagnation (slow economic growth and rising unemployment) such as what occurred to the world economy in the late 70’s and early 80’s. The main cause of this is an adverse supply-side shock (eg. Increase in oil prices, natural disaster etc.) or inappropriate macroeconomic policies (wikipedia.org).
PC Model Transactions Matrix
Equation List for Model PC (endogenous system)
Y = G + C (1)
YD = Y − T + r−1 • Bh−1 (2)
T = θ• (Y + r−1 • Bh−1) (3)
V = V−1 + (YD − C) (4)
C = α1 • YD + α 2 • V−1, 0 < α 1 < α 2 < 1 (5)
Hh/V = (1 − λ0) − λ 1 • r + λ 2 • (YD/V) (6)
Bh/V = λ0 + λ 1 • r − λ 2 • (YD/V) (7) Hh = V − Bh (8)
ΔBs = Bs − Bs−1 = (G + r−1 • Bs−1) − (T + r−1 • Bcb−1) (9)
ΔHs = Hs − Hs−1 = ΔBcb (10)
Bcb = Bs − Bh (11)
r = r* (12)
α3 = α 2 • (1 − α 1)/ α 2 (13)
ΔV = α 2 • (α 3 − V−1) (14)
V*/YD*= α 3 (15)
R*= (B*h • r/V*) (16)
Modify to allow for possibility of stagflation
Inflation is given by π = (p1 - p0/p0), where p is the price level.
The PC model assumes that AD=AS. For stagflation to occur this implies the economy is in disequilibrium, due to the causes mentioned above. In the case of an adverse supply side shock this would imply shortage of supply and excess demand ie. AD>AS. To allow for this the model must be adjusted. Consumption (C) can be increased in nominal terms to become (C.π). This can be substituted into the model instead of C. This includes inflation in the model. Increased inflation will cause a decrease in C which, with G held constant,will lead to a decrease in output/GDP. In a stagflation environment this will lead to an increase in unemployment.
Adverse Supply Side Shock
Figure 1
Figure 1 shows an example of an adverse supply side shock. The AS curve shifts up to the left which results in a fall in GNP, a rise in unemployment (U) and an increase in inflation (π). The linear increase in U and π is contrary to that expected by the Phillips Curve. (Leddin and Walsh 2003, p.31)
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