Describe the factors that can lead to stagflation and explain its negative impact on an economy.
a. Describe the factors that can lead to stagflation and explain its negative impact on an economy. [10]
Introduction
Stagflation refers to a rare and undesirable economic condition where stagnant or negative economic growth occurs alongside persistent inflation. This presents a policy dilemma because the usual tools to fight inflation may worsen unemployment, and vice versa. In a typical business cycle, inflation tends to fall when growth slows. However, stagflation breaks this pattern, resulting in rising prices even when the economy is not expanding, and unemployment is high or rising. Real-world examples of stagflation include the 1970s oil crisis, and more recently, post-COVID recovery periods, where supply shocks and demand uncertainties collided.
Cause #1: Simultaneous Negative Demand and Supply Shocks
Stagflation can result when Aggregate Demand (AD) falls due to weak consumer and business confidence, while Short-Run Aggregate Supply (SRAS) shifts leftward due to rising production costs.
For example, during the COVID-19 pandemic, fear and uncertainty led to a significant fall in Consumption (C) and Investment (I). With tourism and trade disrupted, Net Exports (X – M) also declined. This caused AD to fall from AD₀ to AD₁, reducing real national income (Y) from Y₀ to Y₁, reflecting a slowdown or contraction in economic output.
Simultaneously, the pandemic created widespread supply chain disruptions and labour shortages. Border restrictions delayed shipments, key factories shut down, and essential raw materials like microchips, oil, and food products became scarce. These disruptions increased the cost of production, shifting SRAS leftward from AS₀ to AS₂. The result was a rise in general price level (GPL) from P₀ to P₂, even as real GDP continued to fall further from Y₁ to Y₂.
This combination—a contracting economy with rising inflation—is a textbook example of stagflation.
Cause #2: AD Increases in a Constrained Supply Environment
Stagflation can also arise when AD increases but the economy is operating at or near full employment, and supply constraints prevent any significant growth in output.
In the later stages of the COVID-19 pandemic, governments around the world introduced fiscal stimulus packages to boost demand. As restrictions eased and vaccination rolled out, household spending rebounded, pushing AD rightward. However, the economy’s productive capacity had been permanently affected due to:
Permanent business closures
Loss of labour due to illness, deaths, or withdrawal from workforce
Reduced investment during the pandemic
These factors contributed to a leftward shift in LRAS, meaning the economy could no longer produce the same level of output as before. Even as AD rises, the economy remains stuck near the new, lower full employment output level. The rise in AD simply translates into higher prices (P₁ to P₂), rather than an increase in real output (Y remains constant or barely rises). This leads to inflation without meaningful growth, again resulting in stagflation.
Negative Impacts of Stagflation
Stagflation poses serious macroeconomic challenges:
Higher Unemployment
Falling output means that firms reduce hiring or lay off workers. This leads to a rise in cyclical unemployment, especially in sectors sensitive to demand like retail, hospitality, or manufacturing.Rising Cost of Living
With inflation, the purchasing power of households erodes. Real wages may stagnate or fall, worsening material standard of living, especially for low- and middle-income households who spend a larger portion of their income on necessities.Policy Dilemma for Governments and Central Banks
Fighting inflation requires tight monetary policy (e.g. raising interest rates), which can worsen unemployment. Conversely, tackling unemployment with expansionary fiscal or monetary policy risks fueling further inflation. This makes it difficult for policymakers to respond effectively.Fall in Investment
Uncertainty and rising costs create a hostile environment for private investment. Firms are reluctant to invest in capacity expansion or R&D when demand is weak and costs are high. This hampers long-term growth potential.
Conclusion
Stagflation is one of the most difficult economic challenges a government can face. It can arise from supply-side shocks such as rising commodity prices or logistical disruptions, particularly when combined with weak aggregate demand or constrained productive capacity. The resulting mix of high inflation and low or negative growth leads to severe trade-offs in policymaking and prolonged hardship for households and firms. As seen during the post-COVID era and earlier global crises, preventing stagflation requires a balance of short-term demand management and long-term supply-side resilience, such as investing in productivity and reducing dependence on volatile import sources.
Figure 1: Effects of both a demand and supply shock to the economy
Figure 2: When AD recovers but AS does not
🎓 H2 Exam Pack — The All-in-One Economics Mastery System
💭 Reading model essays helps. But scoring your first L3? That takes structured, strategic practice.
At Economics at Tuitiongenius (ETG) — Singapore’s most trusted provider of H2 economics tuition — we don’t just teach content. We equip students with the thinking frameworks, writing techniques, and exam skills needed to score real distinctions.
And that’s exactly what the H2 Exam Pack delivers.
💥 One Bundle. 5-Grade Jumps.
With A Levels just months away, the H2 Exam Pack gives you a full, proven revision system — without needing to juggle different crash courses from different centres.
📦 What’s Inside:
✅ Micro & Macro Crashcourses — Cover 8 essential A Level topics in depth
✅ Essay & CSQ Bootcamps — Practise 60+ real exam questions, dissected and applied
✅ Skills Boosters — Develop precision with personalised feedback from the ETG team
✅ Printed Materials Delivered — Full content guides, model essays, evaluation templates, and more
✅ Lifetime Access to Recordings — Rewatch every session anytime, anywhere
All taught by Mr Eugene Toh, one of Singapore’s most respected economics tutors, whose methods have helped over 2,000 JC students raise their grades — often by 4 to 5 bands.
💡 Perfect for:
Students rebuilding from a weak J1
Those pushing from a B to a solid A
Anyone searching for economics tuition Singapore that actually teaches you how to think, write, and score
🔗 Register now at tuitiongenius.com/h2exampack
📲 Or WhatsApp 8168 3986 — our admin team will guide you through in under 24 hours
You don’t need another essay to read. You need a system that works. With ETG, the A is closer than you think.