Economies are facing soaring inflation rates despite tepid growth, which commentators have

attributed to various causes. Discuss what you think the appropriate policies are to address
fears of ‘stagflation’.
Q1
Lu Keyang Qingdao No.2 Middle School

Stagflation is one of the world's most serious economic problems and has been discussed
since the 1970s when it first appeared. Keynesian economics(Goutsmedt, n.d.) and new
classical economics(Zinn - Stagflation and the Rejection of Keynesian Economic.Pdf , n.d.)
cannot explain and solve the problem precisely. However, behavioral economics gives us a
new perspective on observing and solving problems.

The supply shock theory and monetary policy are popular theories to explain stagflation and
have advantages and disadvantages. But for behavioral economics, by studying the human
conscious, behavior patterns such as availability heuristic, simulative heuristic, and
representativeness heuristic(Rötheli, 2020). From economists to consumers, these psychology
theories are all in play.

Stagflation is when slow economic growth and joblessness coincide with rising inflation(What
Is “stagflation” and What Does It Mean for the Future Economy? n.d.). And now, it has re-
emerged and is beginning to plague people's lives and harm the global economy. From New
York to Tokyo, inflation continues to surge, and families are struggling with rising living costs.
There are many different opinions about the causes of this stagflation. Still, most favor supply
chain disruptions from China, and the war in Ukraine increases the risk of stagflation(Bill, 2022).
Governments, hiring economists who use traditional economics to analyze this threat, try to
reduce the damage brought by stagflation. However, as if traditional economics itself, the
solutions to stagflation traditional economics offers are imperfect and misleading because
human beings are not rational and can’t weigh the benefits and drawbacks of action and then
choose the option in their self-interest(Behavioral Economics | Psychology Today , n.d.). In
contrast, behavior economics says that human perception is not always precise: systematic
errors recur predictably in particular circumstances(Kahneman, 2011). Hence, behavior
science may be practical in designing policies to alleviate stagflation.

Stagflation has been researched by different economists, including Robert B. Barsky(Barsky &
Kilian, 2001), J. S. Flemming(Flemming, 1987), and J. Marczewski(Marczewski, 1982). Although
they have different understandings of stagflation, the definite ones are that it can be seen as
a recession with the occurrence of high inflation simultaneously (Eng, n.d.). It broke down the
original Phillips Curve, a trade-off between a high inflation rate and a high unemployment
rate. Here is the question, how to tackle stagflation and lower the damage? The most
commonly used method is to launch an interest rate hike. Policymakers try to reduce the
expectation of inflation by adopting restrictive monetary policies and slowing the
economy(The Real Story of Stagflation, n.d.). In this perspective, stagflation can be seen as
just recession or inflation. An interest rate hike will harm the economy and trigger an even
more devastating recession and higher unemployment rate. Another reason central banks are

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not passionate about starting an interest rate hike is that central bank is multi-purpose, and
the first goal may be not to control inflation but stimulate the economy. As a result, although
we know that an interest rate hike would alleviate stagflation, some countries still allow
stagflation to develop.

Speaking of my method to deal with stagflation, Behavioral economics is one of the most
rapidly growing fields in economics and is gradually becoming mainstream. It is motivated by
findings from psychology and uses experimental, field, and neuroeconomic evidence(Dhami
& al-Nowaihi, 2012). traditional economics assumes that rational people are unaffected by
external factors and emotions and can make decisions based purely on what would benefit
them the most(Colich, 2021). But behavioral economics is based on the assumption that
humans are emotional and cannot make the best decision to fit their interests. Kahneman and
Tversky, who can be seen as the founders of behavioral economics, developed the prospect
theory, which claimed that people suffer from cognitive biases that affect their economic
decision-making(Prospect Theory: An Analysis of Decision Under Risk by Daniel Kahneman,
Amos Tversky :: SSRN, n.d.). For instance, individuals prefer the certainty of gain and
uncertainty of loss. Separating from exploring how information is treated in our brain, another
area of behavioral economics research is how others’ behaviors lead individuals. From A
Theory of Equity, Reciprocity, and Competition, we know people are motivated by their
pecuniary payoff and relative payoff standing(Bolton & Ockenfels, 2000). Other factors, such
as equity, also lead to their choice. And this research also refuted the assumption that humans
are only guided by their interests. For instance, if your friends buy a car, you will be more
willing to buy a car than a bike. And on a large scale, this may result in impactful societal
effects(Miller et al., 2015).

To explain and alleviate stagflation, which can be seen as inflation, behavioral economics has
its approaches. Martina Vránková, a Faculty of Finance and Accounting at the University of
Economics, Prague, mentioned that behavioral economics is capable of playing a role in
inflation targeting(Vránková, n.d.). Inflation targeting is a monetary policy where the central
bank sets a specific inflation rate as its goal, which New Zealand first adopted in 1990(Why
the Government Wants You to Expect Inflation, n.d.). This policy gives central banks the right
to control inflation at the best point to stimulate economic growth. Adjusting inflation
expectations to control inflation is a crucial part of inflation targeting. When individuals expect
that there will be high inflation, inflation will come. As a result, inflation expectation has a self-
fulfilling property. In Martina Vránková’s work, inflation expectation is formed by previous
experience and rations created based on all available information(Vránková, n.d.). However,
different researches tend to support other findings about the rational expectation hypothesis.
The expectation can be seen as a psychological factor, so behavioral economics can explain
it. This essay pointed out that based on subjective probability heuristics, economic subject
prediction of future inflation is on guessing.

Hence, Behavioral economics offers a new perspective on solving the problem of stagflation.

Barsky, R. B., & Kilian, L. (2001). Do We Really Know That Oil Caused the Great Stagflation? A

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https://www.psychologytoday.com/us/basics/behavioral-economics
Bill. (2022, June 28). China’s Draconian Lockdown Policies: Major Consequences to Follow
[Text]. Mises Institute. https://mises.org/wire/chinas-draconian-lockdown-policies-major-
consequences-follow
Bolton, G. E., & Ockenfels, A. (2000). ERC: A Theory of Equity, Reciprocity, and Competition.
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