Stagflationary Bias

Stagflationary bias refers to a tendency in the economy or in the policy framework towards the combination of stagnation and inflation. The term is used to describe the conditions that make the economy prone to the simultaneous occurrence of high unemployment and high inflation.

Concept

Stagflation is the combination of stagnation, or high unemployment, and inflation. The term was coined in the 1970s, when the advanced economies experienced both high unemployment and high inflation, a combination that the prevailing framework had not anticipated.

The stagflationary bias refers to the tendency of the economy to generate this combination, and to the factors in the policy framework that contribute to it. The concept is used in the analysis of the failures of policy and of the design of institutions.

Sources

The sources of stagflationary bias include the structure of the labour market and the behaviour of wages. If wages are indexed to prices, an increase in prices raises wages, which raises costs and prices further, creating a spiral that sustains inflation.

The sources also include the presence of supply shocks, which raise costs and prices while reducing output. The oil price shocks of the 1970s are the classic example, and they contributed to the stagflation of that period.

The sources also include the policy framework. A framework that accommodates inflation, by expanding demand in response to supply shocks, can sustain the inflation while doing little to reduce the unemployment.

Policy

The response to stagflation requires a framework that addresses both the inflation and the unemployment. The response includes the anchoring of inflation expectations, through a credible monetary policy framework, and the improvement of the functioning of the labour market.

The response also includes the use of supply-side policies, which raise the productive capacity of the economy and reduce the pressure on costs. The policies include the reform of the labour market, the reduction of the regulatory burden, and the support for innovation.

The design of the policy must balance the objectives, since the instruments that reduce inflation may increase unemployment in the short run, and vice versa. The credibility of the framework is central, since it affects the expectations and thereby the trade-off.

The Modern Framework

The modern framework for monetary policy, based on inflation targeting, is designed in part to avoid the stagflationary bias. The framework commits the central bank to the objective of price stability, and the commitment anchors the expectations of the public.

The framework has been associated with a reduction in the level and the volatility of inflation, and with the improvement in the trade-off between inflation and unemployment. The framework has been tested by the shocks of recent years, and the experience informs the analysis of its design.

The Experience of the 1970s

The stagflation of the 1970s was a turning point in the macroeconomic policy, since it challenged the framework that had dominated the post-war period.

The combination of the high unemployment and the high inflation was not anticipated by the prevailing framework, which had assumed a stable relationship between the two. The experience led to the reassessment of the framework and to the development of the new approaches.

The causes of the stagflation included the supply shocks, the accommodative policy, and the institutional factors including the wage indexation. The analysis of the causes informs the design of the policy to avoid the recurrence.

The Wage Indexation

The wage indexation links the wages to the prices, and it can contribute to the stagflationary bias, since an increase in the prices raises the wages, which raises the costs and the prices further.

The indexation is more common in the economies with the high inflation and the strong unions. The indexation can sustain the inflation, since the increase in the prices is automatically passed into the wages.

The reduction of the indexation is one element of the policy to reduce the stagflationary bias. The reform of the wage setting and the change in the expectations can reduce the spiral.

The Role of the Expectations

The expectations are central to the analysis of the stagflation, since the behavior of the workers and the firms depends on the expected inflation.

When the expectations are not anchored, the increase in the prices leads to the expectation of the further inflation, which leads to the higher wages and prices. The spiral can become self-sustaining.

The anchoring of the expectations is therefore central to the policy. The credible commitment to the price stability and the transparent communication can anchor the expectations and reduce the stagflationary bias.

Summary

Stagflationary bias refers to the tendency towards the combination of the stagnation and the inflation. The analysis of the experience of the 1970s, of the wage indexation, and of the role of the expectations informs the understanding of the policy to avoid the stagflation.

References

^[1] ^[2] ^[3]

↑ Research on stagflation and on the experience of the 1970s.
↑ Studies of inflation targeting and of the anchoring of expectations.
↑ Analyses of the policy response to supply shocks.

[r1-1] Research on stagflation and on the experience of the 1970s.

[r2-2] Studies of inflation targeting and of the anchoring of expectations.

[r3-3] Analyses of the policy response to supply shocks.

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