It is a combination of stagnation and inflation. In this situation rate of unemployment is very high and prices are also rising. While economic growth rate is very low. We may find some features of inflation and recession. In this situation unemployment and inflation co-exist side by side.
Modern economists say that major cause of stagflation is the reduction in aggregate supply of goods. As supply falls, price level rise, but output and employment falls more quickly.
Now question arises that why supply of goods falls? it has following reasons :
1. If the prices of raw material and labour increases, it will increase the cost of production prices will rise and out put will fall.
2. Rapid rise in indirect taxes also increase the cost and price level. So out put and employment falls.
3. Shortage of labour also affects the output adversely.
We can explain the stagflation by the following diagram :
In this diagram aggregate supply curve (SS) intersect the aggregate demand curve (DD) at the point "G". The price level is "OL" and employment level is "OC" when aggregate supply curve moves upward the new equilibrium point of the economy is "F" so due to the fall in supply price increases from OL to OK and employment level falls from OC to OB.
Following are the important measures which can be adopted to control stagflation :
1. To reduce the employment training and skill should be provided to the labour.
2. Money wages should rise with the rise in production.
3. To reduce the cost of production taxes should be reduced.
4. During stagflation govt. should make every effort to control the wages.
5. Tax concession should be given to those firms which keep the wages below the target.
6. Those firms which do not control the wages must pay the penalty.