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Which of the following best explains how an economy can experience stagflation.

  1. Women and teenagers stayed out of the labor force.
  2. Negative supply shock cause the factor prices to increase.

Official answer : 2.

My thoughts: While 2 is correct, I think 1 is also correct. the fact the women and teens stay out of the labor force will increase the wage and thus cause the supply curve to shift to the left and thus cause stagflation. Am I wrong?

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  • $\begingroup$ Are you talking about shocking the labor force (i.e. all women and teens exit market on May 7th, 2015) or an economy in which women and teens are not a part of the labor force? $\endgroup$ – Nox May 7 '15 at 16:22
  • $\begingroup$ In a normal economy, which could cause an stagflation. 1 or 2. $\endgroup$ – Kun May 7 '15 at 16:33
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    $\begingroup$ Number 2 is "best", because it has historical precedent in the United States 1980s, whereas suddenly removing all labor force is unprecedented. "Best" prohibits this type of "both right" answer contesting. $\endgroup$ – RegressForward May 7 '15 at 18:29
  • $\begingroup$ "cause the supply curve to shift and thus cause stagflation". If I were to grade this kind of hand waiving argumentation, it'd get 0 points. $\endgroup$ – FooBar May 7 '15 at 18:59
  • $\begingroup$ @RegressForward Also, the question is which of the following best explains how an economy can experience stagflation. If you replace can with has, empirical precedent is a proper argument. Otherwise, just because it didn't, doesn't mean it won't. $\endgroup$ – FooBar May 7 '15 at 19:07
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Definition In economics, stagflation, a portmanteau of stagnation and inflation, is a situation where the inflation rate is high, the economic growth rate slows down, and unemployment remains steadily high.

Stagflation hence requires a high unemployment rate. The unemployment rate can be defined as

$$ u = \frac{U}{POP}\\ u =\frac{U}{LF} $$

Direct increase of unemployment?

that is, either the number of unemployed over population (more common) or over the labor force. Removing women and teens from the labor force does not affect anything in the first definition, and decreases the unemployment rate by the second definition.

Indirect increase of unemployment?

As stagflation requires a high unemployment rate, reducing the labor force size cannot directly create stagflation. Your only argument could then be that a reduced labor force somehow leads to a higher unemployment rate. Most likely, this is orthogonal. Equilibrium unemployment is a composite of frictional unemployment and voluntary unemployment. I cannot think of a reasonable argument why a reduction of the labor force should increase the relative share of either of these (unless of course, voluntary unemployment is higher among men than women, which is false).

Level effects and growth rate effects

Even more importantly, there is an important distinction between shocks to the level versus shocks to the growth rate. To the extent that - after women and teens have left - the growth rate of the labor force is the same as before, long term effects are negligible.

In a world with exponential growth, a shock to the level is - in the long run - negligible, as we will catch up quite quickly. A shock to the growth rate however, is permanent. Of course, "in the long run" is relative, but there is some idea of persistence behind stagflation. An exit of women from the labor force would, in my opinion, cause a sudden drop in output, but would not affect growth rates.

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  • $\begingroup$ So a drop in output caused by a leftward shift of short run supply curve will cause inflation due to the AD/AS diagram while the AD didn't change, right? $\endgroup$ – Kun May 7 '15 at 19:20
  • $\begingroup$ @Kun You have a bunch of people who are not working any more, and hence have lower income. Are you sure that their demand is the same? $\endgroup$ – FooBar May 7 '15 at 19:23
  • $\begingroup$ @Kun if the answer was sufficient and helpful, don't forget to mark it as such (answered). $\endgroup$ – FooBar May 8 '15 at 13:46

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