Stagflation and its discontents

My essay for the Alfred Marshall foundation

Sep 03, 2022

Hello! It’s been a while. College has been busy, but I will try to be more consistent with my posts. Here is my essay I submitted for the Alfred Marshall Foundation essay contest at Cambridge, discussing the solutions to the threat of stagflation:

Question 1: Economies are facing soaring inflation rates despite tepid growth, which commentators have attributed to various causes. Discuss what you think the appropriate policies are to address fears of ‘stagflation’.

Soaring inflation from an aggressive fiscal and monetary expansion accompanied with lacklustre growth brought about by multifarious supply shocks have lowered real living standards across the world. Solutions to mitigate stagflation involve the reduction in aggregate demand to induce disinflation, and the alleviation of supply-side constraints to expand the productive capacity of the economy to regain losses in living standards. Rich-world economies are faced with both high inflation and sluggish GDP growth. The main cause of high inflation has been the massive fiscal expansion unleashed during the pandemic, with the public debt-to-GDP ratio for OECD economies rising 17 percentage points since the start of the Covid 19 pandemic. In the United States, Federal Reserve assets expanded by over $3 trillion within three months. The savings rate for consumers reached a high of 35% during the pandemic, responsible for much of the economic contraction, as consumer spending makes up 70% of the economy. The low savings rate during the pandemic led to a drop in the money multiplier, which has subsequently accelerated as shown in the drop of the savings rate, accelerating the upward pressure on aggregate demand.While the Fed has started to taper reserves in response to double-digit inflation, the interest rate rise shown in 30-year fixed-rate mortgages has already halted, with rates falling 80 basis points from their peak over the past month. Continued monetary tapering is essential for further inflation reduction, as employment remains strong in the United States and a ‘soft landing’ remains a target for policymakers. In the standard model, a reduction in aggregate demand can increase the severity of recession. However, job vacancies sit near their all time high, suggesting this effect is currently weak, and the US economy can sustain more asset tapering from the Fed before employment becomes an issue.

The aggressive sanctions regime imposed by the United States and European Union on the Russian economy in response to the invasion of Ukraine has created a negative supply shock by disrupting and banning certain kinds of trade, particularly in agricultural products and metals. The main effect of these sanctions on the world economy is an inward shift in the short-run aggregate supply curve, exacerbating inflation and unemployment. Rather than parse out the normative geopolitical questions of the effectiveness of the NATO sanctions regime in this essay, changes in the current trade and tariff regime for the US and Europe offers low-hanging fruit to increase aggregate supply. Eliminating tariffs would eliminate their associated deadweight losses and upward pressure on prices. Eliminating tariffs brought about by President Trump’s trade war would reduce the CPI by 1.3 percentage points according to one analysis (Robinson, 2022). Additionally, reductions in these tariffs would boost exports and overall output. Many economists detract from such economic reforms when economies are in macroeconomic flux, with Vittorio Corbo and Stanley Fisher stating in a World Bank volume: “In countries with acute macroeconomic problems, structural reforms designed to increase efficiency and restore growth...should only be initiated when sufficient progress has been made in reducing macroeconomic imbalances''(Rodrik, 1993). Analysis from Rodrik finds that the effects of trade liberalisation, both their positive fiscal impact and its disinflationary effects will not be limited by macroeconomic instability (Rodrik, 1993). Unleashing the free flow of goods and services to the rest of the world is a crucial step in fighting today’s stagflation.

One cause of the recent economic contraction and the rising cost of services comes from the high rate of baby-boomer retirements during the pandemic. Given that labour (L) is a key factor of net national production in the aggregate production function (Y = F ( K,L )), a decrease in the supply of labour will contribute to slowing economic growth. The Covid-19 pandemic induced more baby boomers into retirement, creating a supply shock in the supply of labour, contributing to the inward shift of aggregate supply (Faria-e-Castro, 2021). By August, 2021, the number of people who had retired before their expected retirement reached 3 million in the United States alone. Ageing populations across the OECD are likely to exacerbate this decline in labour participation, which hasn’t recovered since the start of the pandemic while unemployment has. The main policy lever governments have to increase the supply of labour is through immigration. Due to border closures during the pandemic, the foreign-born working-age population in the United States is an estimated 1.8 million people below trend (Peri and Zaiour, 2022). Immigrants are a key driver of labour force growth in countries where fertility rates are low—70% of the increase in the labour force between 2010 and 2020 was from foreign-born workers (Economist, 2022). Many critics of immigration claim a tight labour market is something that shouldn’t be alleviated because immigrants decrease wages for lower skill workers. Upon reviewing the literature, this is untrue, as analysis of mass migrations show minimal or no effect on low-skill worker wages because the increase in supply of labour is offset by an increase in the demand for labour as immigrants consume goods and services (Card, 1990). The purpose of immigration is to increase the productive capacity of the economy during a time of slow growth, as well as create more businesses to further expand the productive capacity of the economy and further accelerate economic growth. Immigration and Entrepreneurship in the United States finds that, “ immigrants act more as "job creators" than "job takers" and that non-U.S. born founders play outsized roles in U.S. high-growth entrepreneurship”(Azoulay, 2020). Increasing immigration levels to close the gap with the previous trend is wise to ameliorate short and long run supply issues in the age of stagflation.

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