UK Economy in Focus - Stagflation

This revision video considers whether stagflation is a risk for the UK economy in the post-pandemic recovery.

Stagflation refers to a combination of stagnant (slow) economic growth, rising unemployment and high and rising inflation. Stagflation is often associated with spikes in global prices of raw materials and energy such as oil and gas prices especially for countries that rely heavily on imported commodities.

In a situation of stagflation, it becomes difficult to manage the macro economy because, on the one hand, companies and employees are suffering from slow-growing or falling production (which can lead to weaker profits and job losses), whilst prices are rising more quickly which threatens real living standards and can also worsen income inequalities.

What might be causing stagflation in the UK economy?

• External factors such as the steep rise in world oil and gas prices are increasing costs for firms. Many firms are passing these on to consumers in higher prices.
• Increases in the UK energy price cap adding to household energy bills - the UK energy price cap is likely to rise to £2,800 in October 2022, up from £1,971 now
• The changing balance of power in the labour market towards employees might lead to an acceleration in pay demands / wage settlements adding to business costs

Possible consequences of stagflation

1. Real wages may fall as prices rise faster than pay – a fall in real incomes will affect consumer spending
   
   
2. Fall in real incomes may hit poorest families hardest (regressive)
   
   
3. Slower real GDP growth may then hit business profits and planned capital investment which affects productivity growth and productive capacity (LRAS)
   
   
4. Lenders such as banks may demand higher nominal interest rates to combat the impact of inflation
   
   
5. Yields on government bonds might rise making it more expensive to finance a government budget deficit
   
   
6. Impact on AD depends in part on how central banks respond – do they raise interest rates by a significant amount?

Stagflation risks for the UK economy - some evaluation points

• Bank of England response has been muted – base interest rates have risen to only 1% (negative in real terms)
• Slower economic growth will likely bring down inflation in 2023-24 – in part due to a fall in real wages in the UK
• China is now growing at slowest rate for 30 years – this will put downward pressure on global commodity prices
• Risks of a sustained wage-price spiral are lower than in the 1970s / 1980s - markets are more contestable, production is less energy-intensive and trade unions have less collective bargaining power