Which of the following can cause “Stagflation”?
(A) Rapid increase in aggregate demand
(B) Sudden supply shock like rise in oil prices
(C) Expansionary fiscal policy
(D) Appreciation of the domestic currency
The correct answer is (B) Sudden supply shock like rise in oil prices.
Explanation 📉
Stagflation is an economic condition that combines stagnant economic growth (high unemployment) with high inflation (rising prices). This is a particularly difficult situation for policymakers because actions to curb inflation can worsen unemployment, and vice-versa.
The primary cause of stagflation is a negative supply shock. This is an event that suddenly decreases the economy’s capacity to produce goods and services at given prices, leading to cost-push inflation.
A classic example is a sharp rise in oil prices:
- The cost of energy and transportation increases for almost all businesses.
- Facing higher costs, businesses produce less, leading to lower economic growth and layoffs (stagnation).
- To cover their higher costs, they raise the prices of their products, leading to inflation.
Analysis of Other Options
- (A) Rapid increase in aggregate demand: This typically causes demand-pull inflation and is associated with strong economic growth and low unemployment, which is the opposite of stagnation.
- (C) Expansionary fiscal policy: This is a government strategy (cutting taxes or increasing spending) to boost aggregate demand and fight stagnation, not cause it.
- (D) Appreciation of the domestic currency: This makes imports cheaper, which can actually help to reduce inflation. It is not a cause of stagflation.