There is some speculation these days around the potential of covid-19 possibly leading to stagflation for many economies. So what is stagflation and how does it impact economies?
Stagflation is said to occur when the growth rate of a country (can be measured using GDP) becomes either negative or remains stagnant for a sustained period, coupled with an increase in inflation and unemployment.
But why is stagflation a cause of concern?
To understand this, you need to know that the RBI has the authority to keep a check on the inflation rate in India. There is something called repo rate which is the interest rate that RBI sets at which it agrees to keep other banks' money with it. But why would RBI pay banks to keep money with it? Because the role of RBI unlike other banks like HDFC or PNB is not to maximize profits but to govern the country's economy. By setting a high repo rate, RBI pulls money out from the economy as banks find it a much safer option to lend to RBI while getting decent returns. So when repo rates are high, there is less money with the banks to lend, thus less money with people to purchase goods thus reducing demand. When demand reduces, prices of goods start getting slashed thus reducing inflation.
Now the RBI can use this in a reverse way as well. RBI can reduce the repo rate thus making it more appealing to banks to lend to people instead thus pumping in money into the economy. When people have more money to spend, demand for goods increases, and thus prices and in turn inflation increase. But why would RBI want inflation to increase? RBI doesn't. But in times like covid when the economy slows down, RBI wants to boost the recovery for which it has to pump in money into the economy, one way of doing so is by reducing repo rates.
In summary:
So now that we understand that RBI can keep a check on inflation, lets' discuss why stagflation is a concern. In a stagflation situation where inflation and unemployment rate is high, RBI on one hand would want to reduce inflation by increasing repo rate and pulling money out of the economy thus reducing demand thus lower prices. But low prices also mean companies would let people go to meet their profit goals and thus lead to an increase in unemployment. On the other hand, to reduce the unemployment rate, it would need to pump in more money into the economy. Thus you can see how in order to solve both these problems together, RBI needs to take the exact opposite steps. This is why stagflation can be a tricky situation to be in.
Stagflation ends up pushing the country years behind its expected growth trajectory due to low growth, high inflation, and high unemployment rate. Therefore, stagflation ends up causing low growth and low inflation situation and thus is detrimental to an economy.
What can be done in such a situation then?
When signs of stagflation start to appear, the government needs to focus on increasing GDP numbers (can be done in various ways like modifying laws to allow more exports, finding ways to increase farmer income as they constitute about 40% of the working population or provide incentives to foreign companies to invest in India), control inflation and reduce unemployment rate all at the same time.
