Is Stagflation a Problem for the U.S. Today?

In short, stagflation means that there is high inflation at the same time an economy is experiencing production downturns. In other words, low and/or negative GDP with high CPI (the measure of inflation).

The main problem that comes with stagflation is in how it is dealt with by the government. Monetary policy is policy that is done by the Federal Reserve (the Fed) to "persuade" the economy to go in a certain direction, while fiscal policy is what Congress and the President do to get to a desired economic outcome.

The Fed can do a few things - change interest rates for banks, change the amount of cash currency a bank is required to keep in their vaults (called the reserve requirement), or change the amount and size of federal treasury notes sold (called open market operations). When you see on the news that Ben Bernanke, the Chairman of the Board of Governors of the Federal Reserve, has increased (or decreased) interest rates, monetary policy is what's occuring.

Congress and the President, on the other hand, can control government spending and taxes. So, when President Bush encouraged Congress to give tax rebates for people this year, it was fiscal policy.

Now, if there is high inflation, monetary and fiscal policy will both be contractionary. The idea is to get money out of people's hands, because with inflation it means there is just too much currency out there. So, increase taxes or decrease government spending (fiscal policy), or raise interest rates, raise the reserve requirement, or the government selling more treasury notes --- all of these will get cash out of our hands and help control inflation, in theory.

The problem here is that it will also slow down the economy in the sense that people will not be able to spend as much. Usually, if this is done to a large extent, this could cause lowered GDP.

If GDP is falling, monetary and fiscal policy will both be expansionary. For this, the idea is to get more money in consumer's hands. Think of the recent tax rebate, or President Bush's famous "Go to Disneyworld" speech after 9/11. Fiscal policy will encourage a decrease in taxes or an increase in government spending, to get more money to businesses through increased spending. The Fed will decrease interest rates to encourage spending (monetary policy), or decrease the reserve requirement, or buy more treasury notes from people, getting more cash in people's hands.

But now, if that's happening, it increases the money supply...and makes inflation worse.

When an economy is experiencing both high inflation and a decrease in GDP, it is called stagflation. The last time we saw this phenomenon here in the United States was in the 1970's with the oil cartel OPEC limiting our oil supply (hmmm...sound familiar?). This supply shock caused prices to rise, but at the same time, we were experiencing a downturn in the economy, with lowered GDP and increased unemployment.

So then, the government has a problem. Things they do to make inflation better will probably make GDP fall more (and therefore, make unemployment rise). Things they do to make GDP and unemployment better will probably make inflation worse. We got out of it in the early 1980's through Reagan-era tax and spend policies (which also increased the national debt by billions of dollars).

The $10,000 question is - how can stagflation be solved without increasing the national debt?

And if you can answer that, you'll be a rich person...