Monday, August 24, 2009

Stagflation

The situation where higher level of unemployment is attached with higher level of inflation is known as stagflation. Keynesian says that this situation emerges because of increase in costs of production or because of supply shocks. Because of costs push inflation when costs of production increased (due to increase in price of oil or shortage of raw material), the AS curve shifted to left side. The reduced supply of goods will have the effect of increasing the price level as well as reducing the level of output and employment. Accordingly, the economy may experience the situation of stagflation.

The basic equilibrium of economy takes place at E1, where AD = AS1 accordingly OY1 is the level of income and employment while the level of prices is OP1. Because of increase in costs of production, AS curve has shifted to the left side as AS0. The new equilibrium takes place at E0 where AD=AS0. Hence OY0 is the level of output and the price level is OP2. It is obvious that along with increased price level, the level of output has declined which would result in unemployment. The difference between P2 and P1 shows inflation while difference between Y1 and Y0 represents unemployment.

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