Wednesday, September 19, 2007

Searching for a Word

Recession plus inflation equals stagflation.
Stagflation is a problem because the two principal tools for directing the economy, fiscal policy and monetary policy, offer only trade offs between growth and inflation. A central bank can either slow growth to reduce inflationary pressures, or it can allow general increases in price to occur in order to stimulate growth. Stagflation creates a dilemma in that efforts to correct stagnation only worsen inflation, and vice versa. The dilemma in monetary policy is instructive. The central bank can make one of two choices, each with negative outcomes. First, the bank can choose to stimulate the economy and create jobs by increasing the money supply (by purchasing government debt), but this risks boosting the pace of inflation. The other choice is to pursue a tight monetary policy (reducing government debt purchases in order to raise interest rates) to reduce inflation, at the risk of higher unemployment and slower output growth.

I remember how much we were hurt during the last period of stagflation 1979-80. William says we are more immune this time.

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