Stagflation is, economically speaking, the worst of both worlds: economic stagnation and inflation at the same time.
Hence the name—“stag” comes from stagnation and “flation” comes from inflation.
[VIDEO] Understanding Stagflation
Economic stagnation shows its ugly head in multiple ways. However, the two most dramatic numbers economists and politicians watch when evaluating economic stagnation are gross domestic product (GDP) and unemployment.
When GDP numbers are shrinking and unemployment numbers are rising, you have economic stagnation.
Inflation is the loss of purchasing power that comes when a currency becomes worth less and less.
Why Worry About Stagflation?
Stagflation is an incredibly difficult economic problem to solve because the main tool the Federal Reserve uses to boost economic growth and curb inflation—the Federal Funds Rate—can only work on one problem at a time.
If the Fed wants to combat economic stagnation, it typically lowers the Federal Funds Rate.
Conversely, if the Fed wants to combat inflation, it typically raises the Federal Funds Rate.
Obviously, the Fed cannot both lower and raise the Federal Funds Rate at the same time, and thus it has to choose. Should it fight economic stagnation at the cost of rising inflation, or should it fight rising inflation at the cost of economic stagnation?