The term stagflation was coined in the 1970s and combines the words stagnation and inflation. It denotes an economic environment in which both stagnation (the absence of economic growth) and inflation (a decline in the value of a currency and resulting increase in the cost of goods and services) occur simultaneously. Stagflation typically results in increased unemployment and a decline in the standard of living.
Stagflation presents a catch-22 for economic policy makers. The lowering of taxes to encourage economic growth results in inflation. The raising of central bank interest rates to curb inflation results in a decline in economic growth.
Stagflation is usually triggered by unexpected events which weaken economic growth and drive inflation. A good example of stagflation is the oil crisis of the 1970s.
In the 1970s, political tensions resulted in member countries of the Organization of the Petroleum Exporting Countries (OPEC) radically reducing oil production. The reduction in oil extraction drove the value of oil up to unprecedented heights. The sudden hike in oil prices had major repercussions on industrialized countries which were dependent on oil imports, including sharp increases in the costs of manufacturing. This resulted in the cost of goods and services increasing, while manufacturing in these countries slowed.
Inflation increased significantly while economic growth stagnated. The lack of economic growth meant that employees could not expect salary increases and many became unemployed, while at the same time the prices of goods and services climbed steadily. Consumers were forced to navigate the ever-increasing cost of living while their salaries remained the same. The decline in purchasing power resulted in reduced demand for goods and services, which in turn resulted in businesses cutting back their production even further.
See also: Recession