Keynesian Economics.
Stagflation refers to an economic condition where an economy experience stagnation and excessive employment (which remains unchecked for a specified period of time). Keynesian economics attribute stagflation to significant disruptions to the supply side of the supply-demand equilibrium. For example, when there is an artificial scarcity of key goods, resources, or services, production of primary goods are affected. This leads to economic stagnation. The effect however goes beyond stagnation. Scarcity of key commodities triggers excessive inflation. This results , possible, in the contraction of an economy. The 1970s stagflation was generally caused by the failure of the Peruvian anchovy fishery and the 1973 oil crisis. Putting either demand or supply incentive will have no bearing on the actual supply because of relative scarcity. Keynesian economics, therefore, did not offer a realistic solution to the 1970s stagflation.
Supply-side Economics
Supply-side economics rests on the assumption that supply incentives (like tax reductions, the imposition of capital gains tax, and regulation reduction) will lead to steady increases in aggregate supply. If this is the case, aggregate demand shifts rightward (opportunity to increase spending). Inflation follows suit. The gain in consumer and producer surplus is approximately equal to the decrease in government revenues (CS PS -R). The effects 1) budget deficit increases equal to the increase in CS and PS (multiplied by a multiplier, a), 2) higher interest rates, and 3) revaluation of the currency. In the case of the United States, the resurgence of the dollar during Reagans administration tripled the foreign debt of the country. US debtor countries such as Indonesia and Thailand suffered considerably from the revaluation of the US dollar. Because their loans were OPEC recycled dollar, the loans would have to be paid at a higher interest, at the real value. Hence, their debts also tripled as a result.
The effect of an increasing GDP to the trade equation is not direct. After the recovery of 1985, the US faced trade deficit. Germany and Japan were blamed for this de-trickling effect. Germany and Japan were major exporters of primarycapital and secondary goods to the United States. The United States, on the other hand, was a major importer of the two countries. Increases in US GDP triggered increases in domestic supply, but increases in aggregate demand seemed to be exuberant. Thus, increasing the import level in the midst of an economic recovery would increase the trade deficit. Thus, as many economists pointed, the increase in the budget deficit was a humorous direction to the trade deficit. Japan devaluated its currency to compensate for the quantity of exported goods to the United States. However, by devaluing its currency, the country had become a major importer of secondary goods.
The function of the International Monetary fund (IMF) is to oversee the global financial system by following the macroeconomic policies of its member countries, specifically those which concerned exchange rates and balance of payments. It is an organization tasked with the objective of stabilizing international exchange rates and facilitating development. The organization also offers low-interest loans to developing countries (long-term loans). Its developmental program, however, was rendered irrelevant in the 1970s following the failure of the trickle-down policy. The trickle-down policy rests on the assumption that technology adoption would generally trickle down to the lowest strata of societies. The benefits of improved technology, thus, would trickle-down. A qualified development would then result to increases in production and consequently demand.
Stimulus packages are conservative means to increase spending. Currently, the Obama administration is distributing stimulus packages to its citizens for the sole purpose of increasing aggregate spending. This is a classical approach. Increasing spending would naturally stimulate firms to increase production schedules. In theory, this causes a shift in the aggregate supply.
The problem, however, with this policy is the potential effect of crowding out. Suppose the deficit increases and savings remains the same, either investment or net exports must fall, causing trade deficit. Hence, the term twin deficit applies. If foreigners pay for the budget deficit, the trade deficit grows. If the countries citizens savings finance the borrowing, the effect of crowding out magnifies. To solve this problem, there is a need to revaluate the currency of the export-oriented country (say China).