What is stagflation?

Stagflation is defined as an economic situation in which an economy experiences stagnant growth, high unemployment, and high inflation simultaneously. This phenomenon poses a complex challenge for policymakers, as the typical tools used to address inflation, such as raising interest rates, can exacerbate unemployment and hinder economic growth. Conversely, measures intended to stimulate growth, like lowering interest rates or increasing government spending, may further fuel inflation.

In a stagflation scenario, the usual relationship between inflation and unemployment, as described by the Phillips Curve, breaks down. Typically, rising inflation is associated with decreasing unemployment and vice versa, but stagflation showcases how these two issues can coexist, leading to a paradox in economic policymaking. Therefore, the first option accurately encapsulates both the economic stagnation and the inflation that characterizes stagflation.