Stagflation and monetary policy – Theoretical basics

Tibor Erdõs

Public Finance Quarterly, 2008, vol. 53, issue 3, 367-390

Abstract: Any recession in production – or drop in its growth rate – is limited in time. The persistence and depth of each recession, however, may be very different indeed. Often, it is only a decreased growth rate that is observable. If the rate of decrease is considerably higher, is also manifest in a falling absolute level of production, and is also extended in duration, special factors are at play. It must be thoroughly understood why the contractionary spiral emerging in a recession cannot be infinite. A number of factors cause this effect. The rate of decreasing consumption or decelerating growth of consumption is always lower compared to that of income, because the marginal propensity to save drops in times of recession. In such times, households use a portion of their accumulated savings for consumption. Also, the absolute decrease in investments always has a limit at various values in various cases because the annual investments in the corporate sector are not only adjusted to short periodical changes in demand but also to the size of a future capital stock deemed necessary. The state budget either does not reduce its expenses or, if recession is caused precisely by cutting back state expenses, does not continue decreasing expenses beyond an intended limit. By today, services have reached a considerable ratio within total economic performance, and the use of some of them cannot be eliminated even in a bad economic situation. Households would rather borrow credits or use their earlier savings to buy goods, or would request financial assistance from relatives in order not to have to cut back purchasing certain services, or only to a moderate extent. Finally, particularly in small and medium sized countries, foreign trade, and exports directly play an important role. If the setback is not concurrent in all countries, the continued rise in foreign demand sets a limit to declining economic performance.

Date: 2008
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