The phenomenon of stagflation is of comparatively recent origin. It depicts a situation in which prices are sticky and refuse to fall even in the face of poor demand. In other words, it is a combination of stagnation in demand and persistent high prices.
Stagflation arises when there are rigidities in the economic system and production costs, supply flows, demand, and prices do not adjust to each other, and in which, therefore, prices refuse to come down. Let us look at some of the leading possible causes for this phenomenon.
(a) The presence of indirect taxation is an important cause for persistent high cost-price structure of an economy. This is more so when;
i) The taxed goods have low elasticity of demand,
ii) Taxation is not confined to final consumption goods but is levied on intermediate goods and other inputs, and
iii) Taxation is not of pure ‘value-added tax’ variety, but is a multi-point cumulative variety in which taxes have to be paid even on taxes paid earlier.
(b) Wages and prices of essential inputs maybe high and protected by law, so that it is not possible to lower cost of production. The problem becomes further intractable if employment of labor is protected together with the emoluments and if there are restrictions relating to the type of technology to be used.
(c) Policies pursued by the government may be such that productivity and production are not encouraged. This may be done through various restrictions like licenses and permits, etc. Dependence upon official sources of supply involving delays and high costs will also contribute to this outcome.
(d) A country may be critically dependent upon some essential but costly imports like petroleum products.
(e) The producers may be able to adopt oligopolistic and other collusive practices.
(f) Stagflation also persists if government policy allows the producers to enjoy “sheltered market” (that is, they can sell in the domestic market without facing foreign competition). In that case, the sellers do not have an incentive to reduce costs and prices.
(g) There can also be some technical and institutional rigidities which prevent a reduction in costs-and prices even when demand is not strong.