by Stephan Smith on May 24, 2011

We all know that one of the most powerful institutions in the world are central banks. Having the ability to create and issue currency, which is the most popular form of money, and having the ability to manipulate the value of the very currency they issue, a central bank definitely has influence over all aspects of life in established countries. They truly have great power.

But have you ever heard of the the saying, “With great power comes great responsibility.”? I believe that quote comes from the very popular movie, “Spiderman”. That statement is so true, especially in the case of central banking. Since central banks have the power to create and issue money, they are also riddled with responsibilities. Typically, a central bank’s most important and most crucial responsibility is to ensure that the currency they create and issue remains stable in value.

In other words, central banks have to make sure that inflation is kept under strict control and deflation is non-existent. Usually a central bank aims to keep the rate of inflation for an economy around 1.5 to 4 percent, depending on which economy and central bank one is speaking of. If inflation becomes to high, central banks simply have to implement contractionary monetary polices to remove some of the excess credit and cash from an economy’s money supply.

However, whenever a central bank decreases an economy’s money supply, the unemployment rate tends to head higher since there is less money in circulation. The less money in circulation, the less demand there is for goods and services. The less demand there is for goods and services, the less purchasing of those goods and services there will be. The fewer the sales, the great the job losses an economy will experience. And that’s how you get a higher unemployment rate.

The Typical Scenario

Usually, whenever an economy experiences a high level of inflation (not extremely high, but just above central bank inflation targets), an economy usually experiences a relatively low unemployment rate. Why? Because whenever inflation is high, that means credit and cash are more accessible. With credit and cash more accessible, demand for goods and services should increase as well. Ultimately, consumers would be buying more goods and services and thus producers would be hiring more employees to deal with the increasing business.

When inflation is high and the unemployment rate is low to moderate, officials would easily come to the conclusion to tighten monetary policy. Do so would force inflation to come down. Unfortunately, it would usually make the unemployment rate raise, but if it was low to being with, then it shouldn’t cause too much of a problem.

But what happens if an economy experiences high inflation and a high unemployment rate? That is the kind of question that would make central bankers very nervous. Enter in… Stagflation.

What is Stagflation?

Stagflation is a scenario where an economy experiences high inflation and a high unemployment rate simultaneously while demand for goods and services remain relatively flat. Some economists have dubbed stagflation as the perfect storm for economic contraction. But you may be asking, just why is stagflation so bad? Well, I thought you’d never ask.

Stagflation is bad because it puts central bank policy makers in a tough position. When an economy is suffering from high inflation, which is a central banks biggest enemy, it is up to policy makers to take necessary action to subdue the high inflation while being as accommodating to economic growth as possible. There are three options a central bank can take to try to combat stagflation.

  • Tighten Monetary Policy
  • Loosen Monetary Policy
  • Do Nothing

Usually, the way central bankers deal with high inflation is to tighten monetary policy. But here lies the problem. Tightening monetary policy will exacerbate the unemployment rate issue because it will make credit and cash more scarce. With less credit and cash in circulation, the unemployment rate tends to go.

When an economy’s unemployment rate increases, consumers will have less money to spend of goods and services. Thus, demand for those goods and services will decrease and ultimately causing more job loss and an even higher unemployment rate. All of this leads to economic contraction and that is never good because it means the economy is shrinking. No central bank wants to see the economy they’re overseeing to experience economic contraction.

Let’s say that the central bank decides to loosen monetary policy. That will help with the unemployment rate and demand issues, but that will cause inflation to run out of control. When inflation increases wildly out of control, an economy is said to be experiencing hyperinflation. Hyperinflation can bring an economy down because it results in economic conditions that are similar to an economy that is suffering from a high unemployment rate.

With hyperinflation, prices for goods and services increase at too fast a pace, which eventually will cause many goods and services to be too expensive for consumers to purchase. As a result, demand for those goods and services will decrease. Sales will fall and that would lead to job loss and an increasing unemployment rate. All this will lead right back to economy contraction.

The third option a central bank can implement is to do nothing. If a central bank does nothing, then inflation will stay high, the unemployment rate will also stay high and demand will stay flat. Not good either. All three options yield poor results. That’s why stagflation is so dangerous. It really puts the policy makers in a bind.

The Degree or Intensity Factor

There is one factor that I don’t want to omit from this article. That factor is the degree or intensity factor. If a central bank decides to take action, whether is be the tightening or loosing of monetary policy, the central bank can also determine the degree or intensity at which it implements its policies.

So if price stability is at the forefront of it’s a responsibilities (which is usually is), then a central bank may implement contractionary monetary policies at a staggered pace (not so intense) so that the unemployment rate doesn’t get out of hand so quickly. Whatever action a central bank may take to fight off stagflation, be aware that the degree or intensity at which it takes action can also influence the end result.

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