Final answer:
Stagflation is the term for the condition of a declining GDP coupled with rising price levels, and it presents an anomalous situation in traditional macroeconomic theory, challenging the expected relationship between unemployment and inflation.
Step-by-step explanation:
A decline in GDP combined with a rise in the price level is referred to as stagflation. This economic phenomenon is characterized by a stagnating or declining economy coupled with high inflation. Stagflation challenges traditional macroeconomic theories as it doesn't fit the typical pattern where high unemployment is usually associated with low inflation.
The aggregate demand/aggregate supply model is useful in understanding stagflation. For instance, investment by private firms in physical capital can influence GDP. During the late 1990s, investment in the U.S. economy surged, positively affecting GDP. However, if aggregate demand increases more rapidly than aggregate supply, it can lead to higher price levels, contributing to stagflation.
Governments may use fiscal policy to mitigate the effects of stagflation by influencing both demand and supply through government spending and taxation. The history of the U.S. economy provides examples of stagflation during the 1970s and early 1980s, a period when traditional Keynesian economics struggled to explain the concurrent rise in unemployment and inflation.