1. A STUDY OF TRENDS OF INFLATION
AND UNEMPLOYMENT IN INDIAN
ECONOMY
A DESCRIPTIVE ANALYSIS
This term paper is submitted in partial completion of MBA
SUBMITTED TO:
SUBMITTED BY:
Faculty Guide: Mr. Rajneesh Mishra
Student: Ms. Anu Damodaran
Assistant Professor Economics
Registration No: AUD0260
Amity University Dubai
Program: MBA - General
Year: 2012 to 2014
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2. CERTIFICATE FROM FACULTY GUIDE
This is to certify that Ms. Anu Damodaran, Reg. No. AUD0260, a 1 st Year MBA – General
student of Amity University, Dubai, UAE, has carried out her term paper - “A Study of Trends
of Inflation and Unemployment in Indian Economy – A Descriptive Analysis” from 12-Oct2012 to 13-Dec-2012. She has completed the term paper successfully. She has done this term
paper work independently and submitted the same on 13-Dec-2012.
Mr. Rajneesh Mishra, Faculty Guide,
Assistant Professor of Economics,
Amity University, Dubai, UAE
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3. ACKNOWLEDGEMENT
I, Ms. Anu Damodaran, sincerely thank and acknowledge the valuable inputs and guidance
extended to me by Mr. Rajneesh Mishra, Assistant Professor of Economics at Amity University,
Dubai, toward successful completion of this term paper “A Study of Trends of Inflation and
Unemployment in Indian Economy – A Descriptive Analysis”.
I offer my sincere thanks to my husband Mr. Pradeep Kumar Raju for his enduring support in
every aspect for the completion of this term paper.
Thanking you,
Yours sincerely,
Ms. Anu Damodaran
Reg. No. AUD0260,
1st Year MBA – General,
Amity University, Dubai, U.A.E.
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4. TABLE OF CONTENTS
NO. TOPIC
PAGE NO
INTRODUCTION
1.1 OBJECTIVES OF THE TERM PAPER
6
1.2 RESEARCH METHODOLOGY
1
8
7
1.3 LITERATURE REVIEW
11
2.2 ECONOMIC INFLATION
12
2.3 WHAT IS "DEFLATION"?
12
2.4 HOW IS DEFLATION MEASURED?
13
2.5 HOW IS DEFLATION STOPPED?
13
2.6 WHY IS DEFLATION WORSE THAN INFLATION?
14
2.7 CAN DEFLATION EVER BE A GOOD THING?
14
2.8 DEFINITION OF COST-PUSH INFLATION
14
2.9 DEFINITION OF DEMAND-PULL INFLATION
15
2.10 DEMAND PULL AND COST PUSH INFLATION WITH EXAMPLES
15
2.11 ANTICIPATED INFLATION, INVESTMENT, AND THE CAPITAL STOCK
18
2.12 EFFECTS OF INFLATION ITS CONSEQUENCES AND POLICY MEASURES
18
2.13 THE COSTS OF REDUCING INFLATION
20
2.14 INFLATION AS A TAX
21
2.15 MEASURES TO CONTROL INFLATION
22
2.16 INFLATION IN DEVELOPING COUNTRIES
26
2.17 INDIA INFLATION RATE
27
2.18 INFLATION IN INDIA 2012
28
2.19 CONDITION OF THE INR
29
2.20 CONDITION OF EXPORT AND IMPORT
29
2.21 INDIA ECONOMIC GROWTH
3
INFLATION: AN OVERVIEW
2.1 MEANING OF INFLATION
2
8
11
29
UNEMPLOYMENT: AN OVERVIEW
31
3.1 MEANING OF UNEMPLOYMENT
31
3.2 VOLUNTARY VERSUS INVOLUNTARY UNEMPLOYMENT
31
3.3 FRICTIONAL UNEMPLOYMENT
31
3.4 WHAT CAUSES FRICTIONAL UNEMPLOYMENT?
33
3.5 TYPES OF FRICTIONAL UNEMPLOYMENT
33
3.6 STEPS TO REDUCE FRICTIONAL UNEMPLOYMENT
34
3.7 CYCLICAL UNEMPLOYMENT
35
3.8 STRUCTURAL UNEMPLOYMENT
37
3.9 CAUSES OF STRUCTURAL UNEMPLOYMENT
37
3.10 EXAMPLES OF STRUCTURAL UNEMPLOYMENT
38
3.11 STEPS TO REDUCE STRUCTURAL UNEMPLOYMENT
38
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5. 3.12 POLICIES FOR REDUCING UNEMPLOYMENT
39
3.13 DEMAND SIDE POLICIES
39
3.14 POLICIES TO REDUCE SUPPLY SIDE UNEMPLOYMENT
40
3.15 UNEMPLOYMENT IN INDIA
41
3.16 REASONS FOR UNEMPLOYMENT IN INDIA
43
3.17 INFLATION AND UNEMPLOYMENT: WHAT IS THE CONNECTION?
44
3.18 FOUR PHASES OF BUSINESS CYCLE
45
3.19 EXPLANATION OF FOUR PHASES OF BUSINESS CYCLE
46
3.20 THE PHILLIPS CURVE
49
3.21 EXPLANATION OF PHILLIPS CURVE
51
3.22 MONETARIST VIEW OF THE PHILLIP CURVE
52
3.23 STAGFLATION – AN OVERVIEW
53
3.24 WHAT IS STAGFLATION AND WHY IS IT SO DANGEROUS?
54
3.25 WHAT ARE THE CAUSES OF STAGFLATION?
55
3.26 HOW TO PREVENT STAGFLATION
56
4
DATA ANALYSIS
58
5
RESULTS AND CONCLUSION
62
BIBLIOGRAPHY
64
TABLE OF FIGURES & TABLES
NO.
TOPIC
PAGE NO
Fig.2.1
DEMAND PULL INFLATION
16
Fig.2.2
COST PUSH INFLATION
17
Fig.2.3
INDIA INFLATION RATE
28
Fig.3.1
DIAGRAM OF FOUR PHASES OF BUSINESS CYCLE
46
Fig.3.2
PHILLIPS CURVE
51
Fig.3.3
MONETARIST VIEW OF THE PHILLIP CURVE
52
Fig.3.4
STAGFLATION
53
Fig.4.1
CPI INFLATION RATES: 2002-2012
58
Fig.4.2
WPI INFLATION RATES GRAPH (2010-2012)
59
Fig.4.3
UNEMPLOYMENT RATE (%) GRAPH (2002-2011)
60
Fig.4.4
INDIA ECONOMIC FORECAST GRAPH (2012-2016)
61
Table: 4.1
CPI INFLATION RATES GRAPH (2002-2012)
58
Table: 4.2
YEARLY WHOLESALE PRICE INDEX - BASE YEAR 2004-05
59
Table: 4.3
UNEMPLOYMENT RATE (%)
60
Table 4.4
INDIA ECONOMIC FORECAST
61
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6. 1 INTRODUCTION
The topic of the term paper “A Study of Trends of Inflation and Unemployment in Indian
Economy – A Descriptive Analysis” is to know the Inflation's effects on unemployment in the
Indian economy. It is to know whether the effects are positive or negative in nature. In India
inflation and employment rates are playing hide and seek on the basis of global crisis and rural
and urban crisis. For the last three years, since the global financial crisis of 2008, unemployment
rates have been rising in large number of countries. Due to global crisis developed countries
were not left with enough money for investment in developing countries as they had to pay their
debts. Due to this investment in Indian businesses is very less which deprive businesses to buy
enough raw materials for production and when there are less production then unemployment
increases.
Inflation and Unemployment are the two important variables in macroeconomics. The
phenomenon of very high inflation and unemployment is generally bad and should be avoided if
possible. There is considerable disagreement over which of the two is more harmful. Since, a
certain amount of inflation and unemployment is unavoidable and since efforts to reduce one,
usually result in an increase in the other.
Reasons for the priority and urgency to control inflation and unemployment can be appreciated
only after knowing their causes and consequences for the society. There are several effects of
inflation. It has adverse impact on income distribution. A price rise tends to benefit some
individuals and harm others. While for some income earners, income rises more rapidly than
prices during inflation, for many people just the opposite is true. Those who have fixed incomes
are seriously affected as the real income decline during periods of inflation. Inflation also has
effect on lending and savings. Inflation benefits the borrowers at the expense of the lenders and
savers. The saving rate and hence investment rate is affected adversely. Inflation, in a country,
has also adverse effects on foreign trade. The competitiveness of a country may be seriously
affected.1
1
http://www.ijeronline.com/documents/volumes/Vol%203%20Iss%204/ijerv3i4JuAu2012(2).pdf
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7. Regarding unemployment, economists general classify unemployment into three types according
to the causal factors, namely, frictional unemployment, cyclical unemployment and structural
unemployment. The structural unemployment refers to the persons who are between the jobs.
Cyclical unemployment results from business recessions and depressions when total spending in
the economy is below the full employment productive capacity of the economy. In such a
situation, the economy has same natural resources, manpower and productive equipment as
before the cyclical unemployment occurred but the problem is that economy does not produce
because the goods and services being produced are not being purchased. The people were not
buying because they either had lost their jobs or feared the loss of their jobs. Structural
unemployment arises due to a mismatch between job seekers and job openings. It refers to a
situation when both the jobs and job seekers exist but something prevents the filling up the
vacancies. Unemployment has both economic and social implications for a country like India.
Occurrence of unemployment results in the loss of output, loss in revenue of the government and
in consequence disastrous effect on developmental works. The social cost of unemployment
cannot be measured in money terms, but it involves an intolerable amount of human suffering.
Unemployment means loss of self-respect, poverty and frustration. It can even lead to social
unrest in the country. There are other types of unemployment also in developing countries like
India. These are underemployment and disguised unemployment. Disguised unemployment
refers to zero or very low productivity level and is most prevalent in Indian agriculture sector.
The presence of this type of unemployment makes functioning of labor market inefficient.
1.1 OBJECTIVES OF THE TERM PAPER:
1. To relook into the concepts of inflation and unemployment from a macroeconomic
perspective.
2. To study the rate of inflation and unemployment
3. To analyze the rate of inflation and unemployment in Indian economy for the past 10
years and to examine the trends of inflation and unemployment.
4. To explain the problems of inflation and unemployment and their impacts on macro
economy.
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8. 5. To become familiar with basic facts and concerns and to develop a well-grounded picture
of the situation.
1.2 RESEARCH METHODOLOGY
The research method adopted in this term paper is exploratory in nature. It relies on secondary
research such as reviewing available literature and data. In this term paper, exploratory research
has been taken to gain experience that will be helpful to formulate relevant hypothesis for more
definite investigation at some point later. The results of this exploratory research may not be
useful for decision-making by themselves, but they provide significant insight into the given
situation.
1.3 LITERATURE REVIEW
In the paper “The inexorable and mysterious tradeoff between inflation and unemployment “N.
Gregory Mankiw, Sept 2000 states that price stickiness can easily explain why society faces a
short-run tradeoff between inflation and unemployment. The dynamic relationship between
inflation and unemployment remains a mystery. The so-called "new Keynesian Phillips curve" is
appealing from a theoretical standpoint, but it is ultimately a failure. It is not at all consistent
with the standard stylized facts about the dynamic effects of monetary policy, according to which
monetary shocks have a delayed and gradual effect on inflation. The failure to produce a
dynamic relationship between inflation and unemployment that is derived from first principles
and that fits the facts is surely such a puzzle. The economics profession is not likely to ever
reject the short-run tradeoff between inflation and unemployment, so it had better get on with the
task of explaining it.2
2
http://www.nber.org/papers/w7884
http://www.business.otago.ac.nz/econ/research/discussionpapers/DP_1109.pdf
http://bnarchives.yorku.ca/159/01/900101N_Macro_perspectives_on_inflation_unemployment.pdf
http://www.umt.edu.pk/icobm2012/pdf/2C-90P.pdf
http://www.ijeronline.com/documents/volumes/Vol%203%20Iss%204/ijerv3i4JuAu2012(2).pdf
http://www.umt.edu.pk/icobm2012/pdf/2C-90P.pdf
http://www.eurojournals.com
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9. In the paper “Unemployment in the Long Run” Alfred A. Haug, University of Otago and Ian
P. King, University of Melbourne have used a statistical approach is atheoretical in nature, but
provides evidence in accordance with the predictions of Friedman (1977) and the recent New
Monetarist model of Berentsen, Menzio, and Wright (2011): the relationship between inflation
and unemployment is positive in the long run. They have examined the relationship between
inflation and unemployment in the long run, using quarterly US data from 1952 to 2010.
In his paper “Macroeconomic perspectives on inflation and unemployment” by Jonathan Nitzan
(late 1950s) has mentioned that there is a dual love-hate relationship with the Phillips Curve.
Scholars who endorsed the Phillips Curve on the basis of historical evidence were surprised
when it started to crumble as soon as they assimilated it into their macroeconomic models. He
stated that the gradual emergence of stagflation and the progressive breakdown of the Phillips
Curve presented mainstream macroeconomics with the most serious challenge since the Second
World War. Macroeconomists attacked the Phillips Curve but their criticisms sought to modify,
not nullify.
The idea that inflation and unemployment were inversely related was apparently too significant
to discard so the notional relationship was simply ‘augmented’ by auxiliary factors. The cost of
saving the Phillips Curve was substantial. He concluded that to explain stagflation,
macroeconomists resorted to ‘disequilibria, ‘rigidities’ and “exogenous shocks’ and they
abandoned, at least temporarily, the ideal formulation of the neoclassical synthesis.
In the paper “Inflation and Unemployment: The Roles of Goods and Labor Markets Institutions
Lucy Qian Liu, November 23, 2008, says that empirical evidence on inflation and
unemployment suggests that they can be either positively or negatively related in the long run.
The study was on this relationship in an environment in which inflation has differential effects
on employed and unemployed workers. She found that due to either heterogeneous money
holdings or imperfect indexation of unemployment insurance, the unemployed are affected by
the inflation tax to a larger extent than the employed. A higher rate of inflation increases
workers’ incentives to work and generates a negative effect on unemployment.
http://www.eurojournals.com
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10. On the other hand, inflation lowers a firm’s return from creating job vacancies, thereby raising
unemployment. In the steady state the inflation-unemployment relationship is either positive or
negative, depending on goods and labor markets institutions. Sales taxes, the degree of
heterogeneity in money holdings and the market power of firms are major factors determining
the direction of this relationship. Through a comparison of market institutions, the model
generates an inflation unemployment relation that is qualitatively consistent with the empirical
evidence.
In the paper “An empirical study of Phillips curve in India” by Mr. Manoj Kumar,Research
Scholar & Prof. D.C.Vashist, Head, Department of Economics, Central University of Haryana,
Jant-Pali,Temp Building: Govt. B.Ed College(New Building), Narnaul(Mahendergarh) Haryana,
India, brought out the fact that the past studies have found mixed evidence about the shape of the
Phillips curve from being horizontal to vertical. The researchers have also observed that there are
very few studies about the developing countries including India. The present finding does not
support the hypothesis of vertical Phillips curve. There is a trade-off between prices and
unemployment. Rather it suggests that there is a short run Phillips curve in India. The study is
based on secondary sources of data. Regarding data source has been taken from Handbook of
Statistics on Indian Economy, RBI and construction of variables is used from the Indian annual
data for the period 1951-52 to 2007-08.
In the paper “Is There Any Tradeoff between Inflation and Unemployment? The Case of
SAARC Countries” Sagar Katria, Niaz Ahmed Bhutto, Falahuddin Butt, Azhar Ali Domki,
Hyder Ali Khawaja, Javeria Khalid, Sukkur Institute of Business Administration, Sukkur the
aim was to identify the relationship between inflation and unemployment in SAARC countries
from the perspective of Phillips curve. Unbalanced annual panel data of 8 SAARC members
(Afghanistan, Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka) and 6
expected member of SAARC (Republic of China, Russia, Indonesia, Iran, Myanmar and South
Africa) had been used for the period 1980-2010. This paper found significant results; there is a
negative relationship between inflation and unemployment rate in the SAARC Countries.
Concept of Phillips curve holds true.
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11. In the paper “The South Asian Phillips Curve: Assessing the Gordon Triangle” Muhammad
Imtiaz Subhani, Amber Osman and Muhammad Nayaz have investigated the Phillips Curve
in connection with the Gordon Triangle for the South Asian Countries i.e. Pakistan, India,
Bangladesh and Sri Lanka. The systematic investigation is based on historical thirty years of the
rates of inflation and unemployment for the countries outlined. The split analysis of each country
highlights the relationship between inflation and unemployment, which is positive for Pakistan
and negative for Bangladesh, while no relationship has been observed between the two variables
(no Phillips curve) for India and Sri Lanka. The negative impact of unemployment on inflation is
actually the confirmation of Phillips Curve, which is identified for Bangladesh, while the
positive association between the unemployment and inflation (Stagflation) is also observed that
is a confirmation of the Gordon triangle empirically observed and identified for Pakistan.
In the paper “Phillips curves and unemployment dynamics: a critique and a holistic perspective
”Marika Karanassou, Hector Sala and Dennis J. Snower show that frictional growth, i.e. the
interplay between lags and growth, generates an inflation–unemployment tradeoff in the long
run. They argue that a holistic framework, such as the chain reaction theory (CRT), should be
used to jointly explain the evolution of inflation and unemployment.
2 INFLATION: AN OVERVIEW
2.1 MEANING OF INFLATION
The overall general upward price movement of goods and services in an economy (is often
caused by an increase in the supply of money) usually measured by the Consumer Price Index
and the Producer Price Index. Over time, as the cost of goods and services increase, the value of
a dollar or rupee is going to fall because a person won’t be able to purchase as much with that
dollar or rupee as he/she previously could.
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12. 2.2 ECONOMIC INFLATION
Price increases powerfully assist in reducing demand and increasing supply so that inflation can
be brought to a halt. Price controls below market rates and/or the expenditure of national savings
(financial reserves) to hold down monetary devaluation are inflationary. Price controls and the
expenditure of financial reserves subsidize inflationary levels of demand and deter increases in
supply. They make it much more difficult much more painful to bring inflation to a halt and
restore healthy and sustainable economic growth. Many people have vested interests in the
simplistic and invalid concepts that define inflation in terms of the price increases that it causes.
This fallacy is widely accepted without critical analysis.
By defining inflation simplistically in terms of the current rate of price increases economists,
politicians, and others with vested interests in the continuance of the policies actually causing
inflation can pretend that inflation doesn't exist or can minimize its extent for the long periods
when inflationary forces manifest themselves in ways other than in pushing prices higher.
Econometric technicians who have to ignore all economic factors that cannot be expressed as
equations and have to reduce all recognized economic concepts to the simplistic point where they
can be mathematically measured or weighted are forced to ignore the existence and extent of
inflationary forces until those forces cause price increases that can be measured. This is like
those medical tests that never show what is wrong until the patient is already half dead.
2.3 WHAT IS "DEFLATION"?
When prices decline due to productivity increases, the declining prices powerfully increase
purchasing power and demand even as the productivity gains increase supply. Deflation is a
process, not a thing. The real problem is thus to define those factors that cause deflation - those
factors that are "deflationary.” The standard deflation definition is when asset and consumer
prices continue to fall. This may seem like a great thing to consumers, except that the cause for
widespread deflation is a long-term drop in demand. Unfortunately, a drop in demand means that
a recession is probably already underway, with job losses, declining wages, and an ongoing
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13. decline in the value of your home and your stock portfolio. Deflation is a result of businesses
dropping prices in a desperate attempt to get people to buy their products.
2.4 HOW IS DEFLATION MEASURED?
Officially, deflation is measured by a decrease in the Consumer Price Index. However, the CPI
does not measure stock prices, which retirees use to fund purchases, and businesses use to fund
growth. More important, the CPI does not include sales price of homes. Instead, it calculates the
monthly equivalent of owning a home, which it derives from rents. This is very misleading, since
rental prices are likely to drop when there is high vacancy, usually when interest rates are low
and housing prices are rising. Conversely, when home prices are dropping due to high interest
rates, rents tend to increase. Therefore, the CPI gives a false low reading when home prices are
high (and rents are low).
2.5 HOW IS DEFLATION STOPPED?
To combat deflation, the Central Bank must stimulate the economy with expansionary monetary
policy. It reduces interest rates, and increases the money supply, in an attempt to jump-start
economic growth. In addition, the government can offset deflation with expansionary fiscal
policy. It can put more money into circulation by lowering taxes, increasing government
spending, and incurring a temporary deficit to do so. Of course, if the deficit is already at record
levels, that tool becomes less available. Why does expansionary monetary or fiscal policy work?
If done correctly, it stimulates demand. People have more money to spend, and they are willing
to buy now even though they expect prices to continue to fall. Once the government restores
confidence in economic growth, a lot of people will feel like low prices have hit their bottom,
and will "get in while the getting is good." When enough people do this, demand will outstrip
supply and prices will reverse their downward trend.
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14. 2.6 WHY IS DEFLATION WORSE THAN INFLATION?
Like inflation, deflation is very difficult to combat once it is entrenched. As businesses and
people feel less wealthy, they spend less, reducing demand further. Prices drop in response,
giving businesses less profit. Once people expect the price declines, they delay purchases as long
as possible. They know the longer they wait, the lower the price will be. This further decreases
demand, causing businesses to slash prices even more. It is a vicious, downward spiral. Massive
deflation turned a recession into the Great Depression of 1929. As unemployment rose, demand
for goods and services fell. Prices dropped 10% a year. As prices fell, companies went out of
business. More people became unemployed. When the dust settled, world trade essentially
collapsed. The amount of goods and services traded fell 25%, but thanks to deflation the value of
this trade was down 65% (as measured in dollars).
2.7 CAN DEFLATION EVER BE A GOOD THING?
Massive, widespread deflation is always bad for the economy. However, deflation in certain
asset classes can be good. For example, the price of consumer goods, especially computers and
electronic equipment, continues to fall. This isn't because of lower demand, but from innovation.
In the case of consumer goods, production has moved to China, where wages are lower. This is
an innovation in manufacturing, which results in lower prices for many consumer goods. In the
case of computers, manufacturers find ways to make the components smaller, adding more
power for the same price. This is technological innovation, and it keeps computer manufacturers
competitive.
2.8 DEFINITION OF COST-PUSH INFLATION
The text "Economics" (2nd Edition) by Parkin and Bade gives the following explanation for
cost-push inflation: "Inflation can result from a decrease in aggregate supply.
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15. The two main sources of decrease in aggregate supply are:
1. An increase in wage rates
2. An increase in the prices of raw materials
These sources of a decrease in aggregate supply operate by increasing costs, and the resulting
inflation is called cost-push inflation. Other things remaining the same, the higher the cost of
production, the smaller is the amount produced. At a given price level, rising wage rates or rising
prices of raw materials such as oil lead firms to decrease the quantity of labor employed and to
cut production." Aggregate supply is the "the total value of the goods and services produced in a
country" or simply factor "The supply of goods". The supply of goods can be influenced by
factors other than an increase in the price of inputs (say a natural disaster), so not all factor
inflation is cost-push inflation.
2.9 DEFINITION OF DEMAND-PULL INFLATION
Parkin and Bade give the following explanation for demand-pull inflation: "The inflation
resulting from an increase in aggregate demand is called demand-pull inflation. Such inflation
may arise from any individual factor that increases aggregate demand, but the main ones that
generate ongoing increases in aggregate demand are:
1. Increases in the money supply
2. Increases in government purchases
3. Increases in the price level in the rest of the world
2.10 DEMAND PULL AND COST PUSH INFLATION WITH EXAMPLES
Demand-pull inflation happens when aggregate demand (AD) increases in an economy and
intersects the short run aggregate supply curve (SRAS) to the right of where SRAS and long run
aggregate supply (LRAS) cross. This causes some inflation to occur in the short run, and even
more in the long run as the economy adjusts (and the labor market moves back to equilibrium).
Demand-pull inflation can occur for a reason that causes AD to increase but the most common
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16. are expansionary fiscal and monetary policy, and positive expectations about the future
(increased growth/income expectations). Cost-push inflation happens when SRAS shifts to the
left (decreases) and intersects the AD curve to the left of where AD and LRAS cross. This will
cause inflation in the short run, but prices will drop back down again in the long run as the labor
market adjusts back to equilibrium (with wages dropping). Note that some classes ignore the
long run, and only care about where AD and AS cross and in this case cost-push inflation is a
permanent shift in the AS curve causing some amount of inflation.
Fig.2.1
A common question considers whether inflation caused by an increase in wages (such as
increasing the minimum wage) is caused by demand-pull inflation or cost-push inflation. In fact,
it is caused by both. An increase in wages is an increase in the cost of inputs which shifts the AS
curve to the left (a decrease). An increase in wages also translates to an increase in income which
means consumers can spend more making GDP larger and shifting AD to the right (an increase).
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17. Fig.2.2
These two effects happening at the same time mean that the price level must rise, but that the
new equilibrium point is uncertain, depending on whether AD’s increase or AS’s decrease was
greater in magnitude. There are many ways to consider this:
1. The increase in costs is equal to the increase in income to the shifts must be the same and
equilibrium GDP will be the same only at a higher price level.
2. Assume that some of the income is saved or paid in taxes so the AD shift will be smaller
than the AS shift.
3. Finally, you can assume that the multiplier effects from the increase in consumption
spending (and investment from savings and government spending from taxes) is large so
that the AD shift will be larger than the AS shift.
The third scenario probably the most likely, but we do not know for sure unless we have some
equations or data to base it on. So the real answer here is that inflation caused by an increase in
wages is a double whammy of both demand-pull and cost-push inflation, we cannot blame it on
one source.
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18. 2.11 ANTICIPATED INFLATION, INVESTMENT, AND THE CAPITAL
STOCK
Since inflation indirectly taxes the return on investment, higher inflation leads agents to reduce
their investment as well, and the capital stock falls. The falls in consumption and investment
imply that agents work less, and the combination of a lower supply of labor and a lower capital
stock means that output is lower as well. Prolonged and intense inflation upsets many habits of
economic life, confronting consumers with price increases and price dispersions that send them
shopping; making them doubt their ability to maintain their living standards, and downgrade the
value of their career jobs and long-term savings; and forcing them to compile more information
and to try to predict the future--costly and risky activities that they are poorly qualified to
execute and bound to view with anxiety [Okun 1975: 383].
Furthermore, since unanticipated inflation also produced arbitrary wealth redistributions from
some individuals to others. Since the amounts involved can be very large, even for relatively
moderate inflation rates and most people desire security, they naturally regard the possibility of
such redistributions as a serious threat to their livelihood. Each of these factors such as confusion
over price signals, the undermining of social institutions, and the threat of inflationary
redistributions of income and wealth generates its own distinctive welfare losses. If they were
estimable, these losses ought to be included in any sensible estimate of the `true' welfare cost of
real-world inflation, as opposed to the hypothetical welfare costs that arise in models that assume
there is no inflation uncertainty to worry about. But they should not be ignored simply because
we do not know how to estimate them, and they are almost certainly much more important than
the more estimable costs of anticipated inflation.
2.12 EFFECTS OF INFLATION ITS CONSEQUENCES AND POLICY
MEASURES
There is also evidence that output and employment can be reduced by inflation variability or
inflation uncertainty. In his Nobel lecture, Friedman (1977) implied that inflation variability has
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19. a detrimental effect on economic activity by making agents less willing to enter into long-term
relationships and by reducing the effectiveness of market price signals as indicators of relative
scarcity. To the extent that agents have not adjusted to it, higher inflation variability should
therefore lead to a temporary though perhaps long-lasting reduction of output and employment.
However, the Friedman logic applies more naturally to inflation uncertainty than it does to
inflation variability, and modified in this way, it suggests that greater inflation uncertainty should
lead to lower output and employment and higher unemployment. Extending the Friedman story
further, we might also expect inflation variability or uncertainty to reduce the rate of growth of
output as well. There have been a number of attempts to examine these effects empirically.
Maurice Levi and John Makin (1980) postulated that inflation uncertainty should be entered as
an additional variable in an expectations-augmented Phillips curve. Using the standard deviation
of the cross-section dispersion of Livingston inflation expectations as their proxy for inflation
uncertainty, they found that inflation uncertainty had a positive and significant effect on U.S.
unemployment (1980: 1024). Donald Mullineaux (1980) also used a Phillips-curve approach and
a similar measure of inflation uncertainty, and he obtained robust results that suggest that
inflation uncertainty has a positive and very significant and long-lasting effect on unemployment
(1980: 166-67).
Comparable estimates suggest that inflation uncertainty also has a significantly negative impact
on industrial production as well (1980: 167). Mullineaux also allowed inflation uncertainty to
respond to policy, and his results led him to conclude that "even if it were possible to generate a
sustained unanticipated increase in the rate of inflation, within a fairly short period the effect of
added uncertainty would more than offset the employment gains from unanticipated inflation"
(1980: 166-67). Using postwar U.S. data and a Livingston-type index of inflation uncertainty,
Steven Holland (1986: 242) and Lawrence Kantor (1986: 407) found that increased inflation
uncertainty raised unemployment, Yakov Ahimud (1981: 785-786) found that it had a
significantly negative effect on output and a significantly positive one on unemployment, and
Rick Hafer (1986: 367-368) got much the same results as Ahimud using the American Statistical
Association-National Bureau of Economic Research measure of e dispersion of one-period ahead
inflation forecasts instead of the Livingston measure. Richard Froyen and Roger Waud (1987)
found that inflation uncertainty (as measured by the variance of one-period-ahead forecasts of
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20. the price level) had a negative effect on output for their sample of the UK, U.S., Canada, and
West Germany, and Cozier and Selody (1991) found some evidence that output was negatively
affected by inflation variability even when allowance was made for the inflation rate itself.
2.13 THE COSTS OF REDUCING INFLATION
Perhaps the most commonly cited argument against reducing inflation is the cost of the lost
output or employment associated with doing so. If expectations or price or output decisions have
some element of stickiness, reducing inflation could lead to lower output and employment as
indicated by Phillips-curve analysis. If the disinflation persists, macroeconomic theory suggests
that the economy should eventually adjust to the new monetary policy and output and
employment should recover.
According to the natural rate hypothesis of Friedman (1968) and Phelps (1967), the output and
employment losses should be entirely transitory, and output and employment would tend to be
restored to their former natural levels. We would then be comparing the permanent benefits of
lower inflation against the temporary losses resulting from the disinflation needed to achieve it.
According to the more recent hysteresis argument (see, e.g., Blanchard and Summers 1986),
however, the natural levels of employment and output themselves depend on the past history of
those variables. Hysteresis is a situation "where one-time disturbances permanently affect the
path of the economy." (Romer Advanced Macroeconomics page 471). In unemployment,
hysteresis can occur from as results of type described by Insider-outsider Models. Deterioration
of skills from unemployed people lessens their human capital and can exacerbate the effect.
Another source is "labor-force attachment." Unemployed workers must adjust their standard of
living to a lower level, and they can get used to it and not try as hard to achieve the higher
previous level. Longer periods of unemployment also reduce the stigma and hence labor supply
may be permanently lower after demand returns to normal. For instance hysteresis is possible in
Europe. Once unemployment spiked, people adjusted to lower levels of living, the stigma for
being unemployed declined, and their skills declined. This contributes to a higher rate of
unemployment.
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21. In labor economics, the insider-outsider theory examines the behavior of economic agents in
markets where some participants have more privileged positions than others. The theory was
developed by Assar Lindbeck and Dennis Snower. The insiders are those incumbent workers
who enjoy more favorable employment opportunities than the outsiders. The reason for this
disparity is that firms incur labor turnover costs when they replace insiders with outsiders.
Examples of labor turnover costs are the costs of hiring, firing and providing firm-specific
training. Insiders may resist competition with outsiders by refusing to cooperate with or
harassing outsiders who try to underbid the wages of incumbent workers. The implications of
this behavior for employment and unemployment is that there is absence of wage underbidding
even when many unemployed workers are willing to work for wages lower than existing insider
wages (normalized for productivity differences).
When some external shock reduces employment, so that some insiders become outsiders, the
number of insiders decreases. This incentivizes the insiders to set even higher wages when the
economy again gets better, as there are not as many insiders remaining as before, instead of
letting the outsiders to again get jobs at earlier wages. This causes hysteresis, i.e., the
unemployment becomes permanently higher after negative shocks. As unemployment rises,
workers lose their skills through lack of use, for example, and the natural rate of unemployment
itself rises. Unemployment eventually returns to its natural rate, but the natural rate has increased
in the meantime. In addition to the temporary losses from output and employment being below
their natural levels, there would now also be permanent losses from the shifts in the natural
levels themselves.
2.14 INFLATION AS A TAX
A second argument against reducing inflation is that the monetary authorities may want to retain
the use of monetary policy as a form of taxation. The basic argument was set out explicitly by
Phelps (1973) and goes as follows:
If the government had access to theoretically ideal lump-sum taxes that could raise the revenues
it desired without any efficiency losses, then efficiency considerations dictate that the
government should rely only on such taxes. There are also other reasons to question the Phelps
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22. argument. As Garfinkel (1989: 10) and Selody (1990a: 18) have pointed out, the Phelps view of
inflation as a tax tends to overlook the impact of inflation on the tax collection machinery as a
whole. The tax collection system was not designed to operate in an inflationary world, and as
already discussed, inflation actually plays havoc with it.
So, far from the optimal inflation rate being positive from a purely fiscal point of view, there is a
good argument that lowering inflation would not only reduce the direct welfare losses from the
use of the inflation tax per se, but would also reduce the welfare losses from other forms of
taxation as well. It is consequently bizarre, to say the least, to defend inflation on fiscal grounds.
As Peter Diamond and James Mirrlees (1971a, b) have pointed out, intermediate goods should
not be taxed even in a world where non distorting taxes are not available. The Ramsey rule
consequently applies only to final and not to intermediate goods. Applying the DiamondMirrlees result to inflation then tells us that inflation is an inefficient form of taxation quite
regardless of any of the other problems already discussed (see also Kimbrough 1986, Faig 1988)
2.15 MEASURES TO CONTROL INFLATION
1) Monetary Measures
2) Fiscal Measures
3) Other Non-monetary Measures
(1) MONETARY MEASURES
A. Quantitative Methods
1. Raising the Bank Rate:
To control inflation the central bank increases the bank rate. With this the cost of borrowing of
commercial banks from central bank will increase so the commercial banks will charge higher
rate of interest on loans. This discourages borrowings and thereby helps to reduce the money in
circulation.
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23. 2. Open Market Operations:
During inflation, the central bank sells the bills and securities. These cash reserves of
commercial banks will decrease as they pay central bank for purchasing these securities. Thus
the loan able funds with commercial banks decrease which leads to credit contraction.
3. Variable Reserve Ratio:
The commercial banks have to keep certain percentage of their deposits with the central bank in
the form of cash reserve. During inflation, the central bank increases this cash reserve ratio this
will reduce the lending capacity of the banks.
B. The Qualitative Methods
1. Fixation of Margin Requirements:
Commercial banks have to maintain certain fixed margins while granting loans. In inflation
central bank raises the margin to contract credits and reduces the price level.
2. Regulation of Consumer Credit:
For purchase of durable consumer goods on installment basis, rules regarding payments are
fixed. During inflation initial payment is increased and the number of installments is reduced.
These result in credit contraction and fall in prices.
3. Control through Directives:
Certain directives are issued by central bank to commercial banks and they are asked to follow
them while lending. This keeps in check the volume of money.
4. Rationing of Credit:
The central bank regulates the amount and purpose for which credit is granted by commercial
banks.
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24. 5. Moral Suasion:
This refers to request made by central bank to commercial banks to follow its general monetary
policy.
6. Direct Action:
Direct action is taken by central bank against commercial banks if they do not follow the
monetary policy laid by it.
7. Publicity:
The central bank undertakes publicity to educate commercial bank and public about the trends in
money market. By undertaking these measures the central bank can control the money supply
and help to curb inflation.
(2) FISCAL MEASURES
1. Taxation:
The rates of direct and indirect taxes may be raised and new taxes may be imposed. This policy
will reduce the disposable income in the hands of the people and their expenditure.
2. Public Expenditure:
During inflation, the government should reduce its expenditure. This would reduce the income in
the hands of some people. Hence the effective demand would decrease.
3. Public Borrowing:
The government may resort to voluntary and compulsory borrowing. This policy reduces the
income in the hands of some people. Hence the effective demand would decrease.
4. Over Valuation of Domestic Currency:
Currency over valuation of domestic currency makes exports costlier and there is a fall in the
volume of exports. Imports also become cheaper and there is an increase in money supply
causing a fall in prices.
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25. 5. Inducement to Save:
The government should induce savings through incentives. This will reduce the supply of money
and purchasing power of the people causing a fall in prices.
6. Public debt management:
The public debt should be handled in such a way that there is no increase in the supply of money.
Hence the surplus in the budget should be used to repay the public debts.
(3) NON –MONETARY MEASURES/OTHER MEASURES
1. Increase in output:
Every country suffering from inflation should take steps to increase the output of scarce goods
and services. The production of essential goods at the cost of luxury goods can so serve as an
anti-inflationary measure.
2. Price control and rationing:
Price control must be introduced in respect of essential commodities. Also rationing should be
introduced for equitable distribution of essential commodities. The supply of essential goods can
be undertaken through public distribution system to keep the prices in check.
3. Imports:
Imports of food grains and other essential goods which are in short supply should be allowed.
4. Legal action:
Legal action should be taken against hoarders and black marketers.
5. Wage-rate:
During inflation, the rise in wage rate should be linked to rise in labor productivity. This will
help to control inflation.
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26. 6. Check on population growth:
It is essential to check the growth of population by adopting effective family planning devices.
Above all an efficient and honest administration and good discipline among people are essential.
The various measures stated above have to be combined in a proper manner depending on the
situation of the country.
2.16 INFLATION IN DEVELOPING COUNTRIES
Thirty years ago, financial shocks mainly originated in emerging markets. Today, as we are all
too well aware, those financial shocks are also originating in the developed world. Given today’s
volatile world, it may be time for investors to adopt a more nuanced approach to investing in
emerging markets. Rather than using the traditional frameworks such as emerging markets
versus developed markets it is advisable that investors consider creating their international
allocation on a country or regional basis.
The two reasons are:
1. Traditional frameworks are less relevant than they used to be. There are increasing
differences now between how individual emerging market countries are performing, what
their prospects are and where they are in the economic cycle. The same also applies for
developed market economies. Take the BRIC, for instance. It’s the acronym that applies to
the emerging market countries of Brazil, Russia, India and China, and to indices tracking
these economies. While it may be a great acronym, it no longer represents a homogenous
group of countries that are all in a similar stage of economic development. Today, there are
significant differences among the BRIC countries, especially regarding how they are
combating inflation. As a result, if you hold different views of the countries (say, if you love
Brazil and hate Russia) a BRIC fund may be a bad way to implement your view.
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27. 2. Potential for improved risk-adjusted-returns
To be sure, whether investors should focus their equity allocation at the global, regional, or
country level will certainly depend on if they want to express tactical views. Still, I believe
investing on a country or regional basis could help investors potentially gain both flexibility
and better risk-adjusted returns. Past performance does not guarantee future results.
2.17 INDIA INFLATION RATE
The inflation rate in India was recorded at 7.45 percent in October of 2012. Inflation Rate in
India is reported by the Ministry of Statistics and Program Implementation. Historically, from
1969 until 2012, India Inflation Rate averaged 7.8 Percent reaching an all-time high of 34.7
Percent in September of 1974 and a record low of -11.3 Percent in May of 1976. In India, the
wholesale price index (WPI) is the main measure of inflation. The WPI measures the price of a
representative basket of wholesale goods.
In India, wholesale price index is divided into three groups: Primary Articles (20.1 percent of
total weight), Fuel and Power (14.9 percent) and Manufactured Products (65 percent). Food
Articles from the Primary Articles Group account for 14.3 percent of the total weight. The most
important components of the Manufactured Products Group are Chemicals and Chemical
products (12 percent of the total weight); Basic Metals, Alloys and Metal Products (10.8
percent); Machinery and Machine Tools (8.9 percent); Textiles (7.3 percent) and Transport,
Equipment and Parts (5.2 percent).
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28. Fig.2.3
2.18 INFLATION IN INDIA 2012
India’s inflation rate has grown more than expectations in May 2012 with increase in fuel and
food prices. The benchmark wholesale price index has increased by 7.55% compared to the
2011-12 fiscal. In April 2012 it had increased by 7.23%. 37 estimates done by a survey
conducted by Bloomberg News had produced a median figure of 7.5 percent. Other reports have
also shown that India’s imports and exports have been going down in May 2012. In the previous
quarter India’s economic growth rate decreased to its lowest in the last ten years. A major reason
for this was the lack of success of the initiatives for economic liberalization.
The international sales prospects of India also took a beating thanks to the situation involving the
debt crisis of Europe. The RBI is expected, as a result of the slowdown, to decrease borrowing
expenses - the Indian economy, which is one of the largest emerging markets globally, is
struggling with one of its quickest inflations. The rate of increase in the prices of non-food
manufactured goods is a proper indicator of core inflation. In April 2012 this rate was calculated
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29. at 4.77 percent, only to go up to 4.86 percent in May 2012. This information has been collected
by Bloomberg, which also reveals that vegetable prices have increased by 49% compared to
2011, and power and fuel expenses have increased by 11.5%
2.19 CONDITION OF THE INR
In the year gone by, the value of the INR with regards to the US Dollar has gone down. This has
affected the share market negatively as well. Duvvuri Subbarao, the RBI Governor, is expected
to bring down the benchmark repurchase rate by 7.75% and this is going to be a decrease of
0.25%.
2.20 CONDITION OF EXPORT AND IMPORT
The global economy is going through its worst phase after the previous meltdown ended in 2009
and this has forced the authorities to take some steps. In May 2012, India exported goods and
services worth 25.68 billion US dollars – this was a reduction of 4.16 percent compared to May
2011. Anup Pujari, the Director General for Foreign Trade of India, provided provisional
statistics at a media briefing session held in New Delhi. According to the information, imports
have come down to 41.9 billion US dollars, which is a decrease of 7.36 percent. The trade deficit
has been calculated at $16.3 billion.
2.21 INDIA ECONOMIC GROWTH
In the quarter that ended in March 2012, India’s GDP saw a growth rate of 5.3 percent compared
to the quarter that ended in March 2011. This was the slowest rate after 2003. India is the 3rd
biggest economy in Asia but its economic growth, of late, has been rather modest and, even, this
rate has been achieved after the RBI Governor increased the rates by 3.75 percentage points,
which was an unprecedented figure. The change took place from mid-March in 2010 till October
2011 and its major aim was to restrict the inflation. For majority of 2011, India’s inflation rate
was more than 9 percent.
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30. In the BRIC group, which also includes Brazil, China, and Russia, India has the quickest rate in
terms of price increase. Standard & Poor’s has already notified on June 11 that India could be the
first country in this group to not have an investment grade credit rating. Several Indian
companies have been on the receiving end of less-than-desirable economic growth and high price
pressure. Maruti Suzuki India Ltd has witnessed a fall in its car sales during May 2012. The
Indian units owned by General Motors and Ford have found the going tough due to high gasoline
prices3
3
http://www.investorwords.com/2452/inflation.html#ixzz2DmTlQ3t2
http://www.futurecasts.com/Understanding%20Inflation.html
www.historyhouse.co.uk/articles/coin_clipping.html
www.tudorhistory.org/glossaries/d/debasement.html
http://www.ehow.com/about_5435731_hard-currency.html#ixzz2EBXd8dvV
http://useconomy.about.com/od/pricing/f/Deflation.htm
http://economics.about.com/cs/money/a/inflation_terms.htm
http://www.freeeconhelp.com/2012/04/demand-pull-and-cost-push-inflation.html
http://www.scribd.com/doc/55831120/3/MEASURES-TO-CONTROL-INFLATION
http://articles.economictimes.indiatimes.com/2012-11-27/news/35385732_1_brics-countries-headline-inflationessential-food-products
http://business.mapsofindia.com/inflation/
http://www.tradingeconomics.com/india/inflation-cpi
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31. 3 UNEMPLOYMENT: AN OVERVIEW
3.1 MEANING OF UNEMPLOYMENT
Total number of able men and women of working age seeking paid work. Unemployment
statistics vary according to how unemployment is defined and who is deemed to be part of the
workforce. International labor organization (ILO) computes unemployment on the basis of
number of people who have looked for employment in the last four weeks and are available to
start work within two weeks, plus those who are waiting to start working in a job already
obtained. Unemployment is the state of an individual looking for a paying job but not having
one. Unemployment does not include full-time students, the retired, children, or those not
actively looking for a paying job. Simply put, unemployment is a situation in which an
individual in an economy is looking for a job and can't find one. That said, economists divide
unemployment into a number of different categories, since defining types of unemployment
more precisely sheds some light on why unemployment occurs and what can be done about it.
3.2 VOLUNTARY VERSUS INVOLUNTARY UNEMPLOYMENT
At a very basic level, unemployment can be broken down into voluntary unemploymentunemployment due to people willingly leaving previous jobs and now looking for new ones and
involuntary unemployment- unemployment due to people getting laid off or fired from their
previous jobs and needing to find work elsewhere. Not surprisingly, economists generally view
involuntary unemployment as a larger problem than voluntary unemployment since voluntary
unemployment likely reflects utility-maximizing household choices.
3.3 FRICTIONAL UNEMPLOYMENT
Frictional unemployment is unemployment that occurs because it takes workers some time to
move from one job to another. While it may be the case that some workers find new jobs before
they leave their old ones, a lot of workers leave or lose their jobs before they have other work
lined up. In these cases, a worker must look around for a job that it is a good fit for her, and this
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32. process takes some time. During this time, the individual is considered to be unemployed, but
unemployment due to frictional unemployment is usually thought to last only short periods of
time and not is specifically problematic from an economic standpoint. This is particularly true
now that technology is helping both workers and companies make the job search process more
efficient. Frictional unemployment can also occur when students move into the work force for
the first time, when an individual moves to a new city and needs to find work, and when women
re-enter the work force after having children. For example, redundant workers or people joining
the labor market for the first time such as university graduates may take time searching to find
the work they want at wage rates they are prepared to accept.
Imperfect information in the labor market may make frictional unemployment worse if the
jobless are unaware of the available jobs. Incentives problem can also cause some frictional
unemployment as some people looking for a new job may stay out of work if they believe the tax
and benefit system will reduce the net increase in income from taking work. When this happens
there are disincentives for the unemployed to accept work and this is known as the
unemployment trap. In short, frictional unemployment happens when it takes time for the labor
market to match the available jobs with those people seeking work. Frictional unemployment is
something that always exists, even in the fully developed economies. It is natural for a person to
quit one job to search for a better one.
To understand the concept in a better way, have a look at some examples mentioned below. A
fresh college graduate looking for a suitable job after passing out and not taking any random job
till he / she finds something more suitable. Companies are not hiring employees because there is
a mismatch between the required skills and the jobs available. Many organizations that hire on
seasonal basis will eventually lead to frictional unemployment during off season, while the
employees would look for other suitable jobs.
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33. 3.4 WHAT CAUSES FRICTIONAL UNEMPLOYMENT?
As mentioned earlier, the frictional unemployment rate can never be zero in an economy. And
this fact is applicable even to the highest paying economies in the world. This is the reason why
no economy reaches the state of full employment. This makes frictional unemployment different
from other kinds of unemployment. Let us have a look at the causes of frictional unemployment.

The relationship between workers and employers tends to be heterogeneous in some or
the other way. This mismatch can lead to frictional unemployment, which makes it
closely related to structural unemployment.

Fresh graduates looking for a good job, but are not able to get it right away because of
certain demands by the employers in terms of skills and experience, therefore resulting in
frictional unemployment. Factors related to preference, work environment, skills,
remuneration, and location, work timings, etc., always raise a sense of dissatisfaction in
the workers or employers. This is one of the main causes of frictional unemployment.

There are many workers who wait to reenter their jobs. An example for the same would
be homemakers, new mothers, etc.
3.5 TYPES OF FRICTIONAL UNEMPLOYMENT

In some employment sectors, workers receive more than the price-adjusted equilibrium
wage. This restricts the amount of employment in the high-wage sector and attracts
workers from other sectors who wait to get jobs in this high-paying sector. This creates
“wait unemployment,” a type of frictional unemployment. Some sectors such as
agriculture and tourism require seasonal workers and lay off employees during the offseason. This creates “seasonal unemployment,” another type of frictional unemployment.
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34. 3.6 STEPS TO REDUCE FRICTIONAL UNEMPLOYMENT
Though the rate can never go down to zero, there are certain policies and solutions that can be
applied to reduce the rate of frictional unemployment in an economy. These are discussed as
follows.

Proper educational advice to college students in terms of the job demands and skills
required to get job faster.

Reduction in employment discrimination

Proper training facilities should be provided at schools and colleges.

Attempts to reduce the difference between the gross income and the net income.

Proper channel of information should be used to provide details of the available jobs and
potential workers.

If any biased approach exists in the work environment in terms of employees, job
location etc., then proper action must be taken against it.

More facilities should be provided to enable more flexibility and availability.

Though frictional unemployment is a type of unemployment, it is not considered to be
bad. On the contrary, it is considered beneficial because it gives an opportunity to both
the workers and the organizations to look for the best suitable options. If frictional
unemployment didn't exist, then most of the people would have been working in the same
jobs all their life, making it impossible to have a scope for growth, innovation and skill
development. A little bit of friction is required to increase the pace, and frictional
unemployment gives us the opportunity to do the same. Factors related to preference,
work environment, skills, remuneration, and location, work timings, etc., always raise a
sense of dissatisfaction in the workers or employers. This is one of the main causes of
frictional unemployment.

There are many workers who wait to reenter their jobs. An example for the same would
be homemakers, new mothers, etc.
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35. 3.7 CYCLICAL UNEMPLOYMENT
It's probably not surprising that unemployment is higher during recessions and depressions and
lower during periods of high economic growth. Because of this, economists have coined the term
cyclical unemployment to describe the unemployment associated with business cycles occurring
in the economy. Cyclical unemployment occurs during recessions because, when demand for
goods and services in an economy falls, some companies respond by cutting production and
laying off workers rather than by reducing wages and prices. (Wages and prices of this sort are
referred to as "sticky."). When this happens, there are more workers in an economy than there are
available jobs, and unemployment must result. As an economy recovers from a recession or
depression, cyclical unemployment tends to naturally disappear. As a result, economists usually
focus on addressing the root causes of the economic downturns themselves rather than think
directly about how to correct cyclical unemployment in and of it.
Cyclical unemployment is a term in economics, which is based on a greater availability of
workers than there are jobs for workers. It is usually directly tied to the state of the economy.
Lower demand for products due to lack of consumer confidence, disinterest, or reduction in
consumer spending results in the workforce cutting back on production. Since production is
reduced, companies that retail such products may also cut back on workforce, creating yet more
cyclical unemployment. The reason this type of unemployment is called cyclical is because it is
usually linked to a country’s business cycle, a system of evaluating how gross domestic product
changes over time. Length of time is not always predictable in a business cycle, which includes
four basic periods. At the beginning of a business cycle, a slowdown in economic activity occurs
resulting in a sharp drop into a trough, which hits the lowest point of the economic cycle and
would be linked to the highest unemployment rate. Gradually, through a variety of factors, pace
of economic activity increases in the expansion period, and then the business cycle hits its peak,
which translates to economic recovery and more available work.
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36. Cyclical unemployment begins to occur during the first part of the business cycle and reaches its
peak when the business cycle is in the bottom of the trough. As economic recovery begins, more
jobs become available. When the business cycle peak is hit, there may be more jobs than there
are workers, the opposite of cyclical unemployment. Typically, business cycles are of short
duration, but occasionally, long-term economic factors create not recession, but depression. This
can mean that the actual time the economy sputters and falters can last for several years, creating
severe unemployment for a long time period.
When a country is in a depression, governments may act by lowering taxes and interest rates to
improve consumer demand and spending, and also by creating jobs. In the Great Depression in
the US, the government-created jobs ended part of the cyclical unemployment problem. More
jobs were offered, and the economy really picked up at the onset of World War II. Other factors
can create cyclical unemployment. When work traditionally done inside a country is outsourced,
this can heighten unemployment rates. Until workers can be retrained for other positions or find
jobs where demand still remains high, they may experience long periods of unemployment.
Cyclical unemployment may also be defined as a negative correlation between Gross Domestic
Product (GDP) and unemployment rate. As Gross Domestic Product shrinks, unemployment rate
expands. It has an impact on the ability for an economy to recover, since fewer jobs create less
consumer spending, and less demand. It also creates higher government spending in order to help
those people who require unemployment checks, and welfare or financial assistance. Usually,
economic recovery does begin, but how it does so can vary with each business cycle.
Therefore this type of unemployment is considered temporary, at least in economic recession,
and based on the economic cycle, it will tend to cease over time when the economy moves out of
the business cycle trough and begins to climb into recovery and then to its peak. For example, in
the US the housing sector employs more people for construction and sales during the non-winter
months and housing booms. Likewise, unemployment rises during times of economic slowdown
and recession, as lower demand for services and goods causes business to lay-off workers and
gives less incentive to hire new workers. One key is to maintain workers' connection to the labor
market by providing employment opportunities. If workers lose their attachment to the labor
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37. market, the evidence suggest they can become a long-term problem, and policymakers need to do
much more than they are doing to create short-term opportunities for unemployed workers to
prevent this from happening.
3.8 STRUCTURAL UNEMPLOYMENT
There are two ways to think about structural unemployment. One way is that structural
unemployment occurs because some labor markets have more workers than there are jobs
available, and for some reason wages don't decrease to bring the markets into equilibrium.
Another way to think about structural unemployment is that structural unemployment results
when workers possess skills that aren't in high demand in the marketplace and lack skills that are
in high demand. In other words, structural unemployment results when there is a mismatch with
workers' skills and employers' needs. Structural unemployment is thought to be a pretty
significant problem, mainly because structural unemployment tends to be largely of the longterm variety and retraining workers is not a cheap or easy task. Structural unemployment can
create a higher unemployment rate long after a recession is over. If it is ignored by policymakers, it can then even lead to a higher natural unemployment rate.
3.9 CAUSES OF STRUCTURAL UNEMPLOYMENT
Structural unemployment can be created when there are technological advances in an industry.
This has happened in manufacturing, where robots have been replacing unskilled workers. These
workers must now get training in computer operations to manage the robots and other
sophisticated technology to get jobs in the same factories they worked in before. Structural
unemployment can also be caused by trade agreements, such as NAFTA (North American Free
Trade Agreement). When trade restrictions were eased, many factories relocated to Mexico,
leaving their prior employees without a place to work.
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38. 3.10 EXAMPLES OF STRUCTURAL UNEMPLOYMENT
Structural unemployment can also occur if a country's economic growth is dependent upon
industries that are in decline. For example, the newspaper industry had been in decline since
2000, as web-based advertising had taken over its source of revenue. Employees, such as
journalists, printers and newspaper delivery boys, who were dependent upon that industry,
contributed to structural unemployment after they had been laid off. Since their skills were
narrowly focused on the newspaper's method of distributing news, they had a harder time getting
a different job unless they are retrained. Farmers in emerging market economies are another
example of structural unemployment.
As free trade allowed global food corporations access to their markets, small-scale farmers were
put out of business. They couldn't compete with the lower prices of the global firms. As a result,
they headed to cities in search of work. This structural unemployment existed until they were
retrained, perhaps in factory work. Seasonal unemployment is, not surprisingly, unemployment
that occurs because the demand for some workers varies widely over the course of the year.
(Pool lifeguards, for example, probably experience a decent amount of seasonal unemployment).
Seasonal unemployment can be thought of as a form of structural unemployment, mainly
because the skills of the seasonal employees are not needed in certain labor markets for at least
some part of the year. That said seasonal unemployment is viewed as less problematic than
regular structural unemployment, mainly because the demand for seasonal skills hasn't gone
away forever and resurfaces in a fairly predictable pattern.
3.11 STEPS TO REDUCE STRUCTURAL UNEMPLOYMENT

While totally eliminating structural unemployment is probably unwise, if not impossible,
it can be reduced through education and training programs.

Education and training are the solution to structural unemployment, but there is a catch.
The benefits accrued from education depend directly on the number of productive years a
worker has remaining before retirement. The young incur the investment expense of a
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39. formal education (college) because they have forty-plus years to recoup this cost.
Whereas the closer a person is to his retirement re-education and training provides little
help to the economy.

Of some importance, expansionary fiscal and monetary policies have little if any long
term effect on structural unemployment. While stimulating the economy can reduce
structural unemployment temporarily, so long as technological progress continues,
structural unemployment eventually returns to its "natural" level.

While stimulating the economy can reduce structural unemployment temporarily, so long
as technological progress continues, structural unemployment eventually returns to its
"natural" level.
3.12 POLICIES FOR REDUCING UNEMPLOYMENT
There are two main strategies for reducing unemployment:

Demand side policies to reduce demand-deficient unemployment (unemployment caused
by recession)

Supply side policies to reduce structural unemployment (the natural rate of
unemployment)
3.13 DEMAND SIDE POLICIES
1. Fiscal Policy
Fiscal policy can decrease unemployment by helping to increase aggregate demand and
the rate of economic growth. The government will need to pursue expansionary fiscal
policy; this involves cutting taxes and increasing government spending. Lower taxes
increase disposable income and therefore help to increase consumption, leading to higher
aggregate demand (AD). With an increase in AD, there will be an increase in Real GDP
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40. (as long as there is spare capacity in the economy.) If firms produce more, there will be
an increase in demand for workers and therefore lower demand-deficient unemployment.
Also, with higher aggregate demand and strong economic growth, fewer firms will go
bankrupt meaning fewer job losses. Keynes was a strong advocate of expansionary fiscal
policy during a prolonged recession. He argued that in a recession, resources (both capital
and labor) are idle; therefore the government should intervene and create additional
demand to reduce unemployment.
2. Monetary Policy
Monetary policy would involve cutting interest rates. Lower rates decrease the cost of
borrowing and encourage people to spend and invest. This increases AD and should also
help to increase GDP and reduce demand deficient unemployment.
3.14 POLICIES TO REDUCE SUPPLY SIDE UNEMPLOYMENT
1. Education and Training.
The aim is to give the long term unemployed new skills which enable them to find jobs in
developing industries, e.g. retrain unemployed steel workers to have basic I.T. skills
which helps them find work in service sector. However, despite providing education and
training schemes, the unemployed may be unable or unwilling to learn new skills. At best
it will take several years to reduce unemployment.
2. Reduce Power of trades unions.
If unions are able to bargain for wages above the market clearing level, they will cause
real wage unemployment. In this case reducing influence of trades unions (or reducing
Minimum wages) will help solve this real wage unemployment.
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41. 3. Employment Subsidies.
Firms could be given tax breaks or subsidies for taking on long term unemployed. This
helps give them new confidence and on the job training. However, it will be quite
expensive and it may encourage firms to simply replace current workers with the long
term unemployment in order to benefit from the tax breaks.
4. Improved Geographical Mobility.
Often unemployed is more concentrated in certain regions. To overcome this
geographical unemployment, the government could give tax breaks to firms who set up in
depressed areas.
3.15 UNEMPLOYMENT IN INDIA
There are more than 6 crore well educated youth in India who is unemployed. There has been a
drastic increase in the literacy rate in India over the past few decades, unfortunately leading to a
massive increase in the unemployment rate. The share of agriculture in the total employment has
come down from 61.67% in 1993-94 to 52% in 2004-05.
It is a threatening decrease considering the fact that Agricultural income is a major share of
Indian Economy. Trade, hotel, restaurant, transport and communications sector showed a growth
in the employment rate. But, as said earlier the jobs in these sectors are highly vulnerable and
they tend to impart a sense of insecurity feeling among the employees. Most of the youth are left
to pursue a self-employment or small scale business career. But, they too had a severe blow with
the raising number of multinational companies, supermarkets and wholesale shopping malls. In
India, it seems that there is a huge money flow but this flow bypasses the poor.
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42. Various types of Unemployment seen in India:
1. Structural Unemployment: When demand for work falls short of the supply of labor
force, this type of unemployment arises. Unemployment in India is basically of this
category. Huge population is a main factor for this.
High population  More Job Seekers  STRUCTURAL  Less jobs
2. Under-employment: Some people are employed, but their efficiency and capability are
not utilized to the optimum level. This kind of employment is increasing due to cut throat
competitions and people who are more qualified than necessary also are willing to do a
lesser job to get a job security. This is usually seen in the Public sector. This is uniquely
dangerous in itself because an under-employed person may either develop disinterest in
his work or may opt to corruption to earn more money which he thinks he ought to get for
his over-qualification.
High Competition  UNDER-EMPLOYMENT  Corruption  Black Money  fall
in the Economy
3. Seasonal Unemployment: This occurs due to change in the demand with change in the
seasons. Agriculture and agriculture related sectors experience this kind of
unemployment. Indian Agriculture ensures employment for only 7-8 moths and the
agricultural labors remain unemployed for the rest of the year.
Dry Season  No crops  SEASONAL UNEMPLOYMENT  Urban Migration
4. Open Unemployment: When people who are willing to work and are capable to work
cannot find any work, they come under this category. Educated unemployment and
unskilled labor unemployment are of this kind. The increasing migration from rural to
urban areas is the main cause for this.
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43. Urban Migration  OPEN UNEMPLOYMENT  Slum Dwelling  Communicable
Disease  Prostitution  Antisocial Behavior
3.16 REASONS FOR UNEMPLOYMENT IN INDIA
Population Growth – Reproduction seems to be the recreation of choice for Indians. There can be
no other explanation of the obscene increase in the country’s population. Now, people are born,
raised, educated, fed, and a whole lot of resources are used up the process. The money spent in
these resources could be saved and employment opportunities could be created. Secondly, since
the amount of money invested in creating jobs is not very high, the number of jobs created is not
very high. And the population is increasing, which renders a large portion of people unemployed.
Limited Land – You are a farmer. You own 5 acres of agriculture land. You have 5 sons and 2
daughters. You divide the land amongst them. They have children. They divide their share of the
lad amongst their children. And this goes on for generations. Finally, there comes a time, when
the number of your descendants is so high, that it is impossible to divide the land anymore. The
result – most of them remain unemployed.
Seasonal Agriculture – Farmers can grow only a limited type of crops on their land. They can’t
help it. Their land has minerals and composition that is suitable only to very limited crops. These
crops are planted and harvested only once a year. The remaining months, they are left with
absolutely nothing else to do. They do have the option of working on others’ fields, but the
money is way lesser than what they would make on their fields.
Decline of Cottage Industries – A large number of industries and factories are burgeoning at
every nook and corner. They are producing high quality material which is available to the
consumers at a very reasonable rate. The produce of cottage industries, try as they may, can
never match the quality of these machine made products. People buy better products available at
an economical rate. Cottage industries stop making profits. People working with them are left
without a job.
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44. Defective Education – India’s education system is highly theory oriented. The custodians are
happy as long as students score well, irrespective of whether they have actually understood
anything. The lack of proper understanding of the concepts leads to people not being worthy of
employment.
Lack of transport and communication – On one hand, we have cities like Mumbai that are
extremely well connected. On the other hand, we have remote villages, where even the Indian
Postal Service does not have an office. Now, people living in these villages are forced to remain
within the confines of their villages as they do not have the means to move out and explore a
new lifestyle, or start a new business, or look for other forms of employment.
If you think that the government has a grip on unemployment numbers, you are mistaken. Our
government did not even start counting the number of unemployed people before 2008!
3.17 INFLATION AND UNEMPLOYMENT: WHAT IS THE
CONNECTION?
The relation between unemployment and inflation has long held the attention of economists. For
some time, it was believed that there was a trade-off between the two that policymakers could
exploit. In other words, a lower unemployment rate could be had by tolerating a higher rate of
inflation. That notion is no longer widely held, at least as regards the long run. While minimal
unemployment might seem a desirable policy goal, few economists would define full
employment as employment where everyone who wants a job. Instead, many would argue that
full employment is the lowest rate of unemployment consistent with a stable rate of inflation.
This rate is known as the natural rate of unemployment. Some idea of what that rate of
unemployment is could be extremely useful to economic policymakers.
Inflation tends to be slow to respond to those changes in policy which affect it. The effects of an
expansionary monetary policy on inflation, for example, might not become apparent for some
time. Similarly, at times when the inflation rate is relatively high it is likely to respond only
slowly to policies designed to bring it down. In part because of this characteristic, and because
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45. policies aimed at reducing inflation may have short-term economic costs, it seems to be the
prevalent view that it would be better to avoid increases in inflation altogether.
Perhaps the key characteristic of the natural rate is that it is the lowest rate of unemployment that
is sustainable. If the natural rate model is correct, policymakers seeking to maintain the actual
unemployment below the natural rate would eventually have to contend with an accelerating rate
of inflation. Because inflation tends only gradually to respond to changes in underlying
economic conditions, a way of predicting it or of identifying the conditions that are likely to lead
to an increase in the inflation rate, would be extremely useful to policymakers. The natural rate
of unemployment has been viewed by many economists as a means of measuring tightness in the
labor market and thus the risk of future increases in the inflation rate.
3.18 FOUR PHASES OF BUSINESS CYCLE
1. Prosperity Phase: Expansion or Boom or Upswing of economy.
2. Recession Phase: From Prosperity to Recession (upper turning point).
3. Depression Phase: Contraction or Downswing of economy.
4. Recovery Phase: From Depression to Prosperity (lower turning Point).
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46. Diagram of Four Phases of Business Cycle
Fig.3.1
The business cycle starts from a trough (lower point) and passes through a recovery phase
followed by a period of expansion (upper turning point) and prosperity. After the peak point is
reached there is a declining phase of recession followed by a depression. Again the business
cycle continues similarly with ups and downs.
3.19 EXPLANATION OF FOUR PHASES OF BUSINESS CYCLE
1. Prosperity Phase
When there is an expansion of output, income, employment, prices and profits, there is also a rise
in the standard of living. This period is termed as Prosperity phase. The features of prosperity
are:-
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47. 1. High level of output and trade.
2. High level of effective demand.
3. High level of income and employment.
4. Rising interest rates.
5. Inflation.
6. Large expansion of bank credit.
7. Overall business optimism.
8. A high level of MEC (Marginal efficiency of capital) and investment.
Due to full employment of resources, the level of production is Maximum and there is a rise in
GNP (Gross National Product). Due to a high level of economic activity, it causes a rise in prices
and profits. There is an upswing in the economic activity and economy reaches its Peak. This is
also called as a Boom Period.
2. Recession Phase
The turning point from prosperity to depression is termed as Recession Phase.
During a recession period, the economic activities slow down. When demand starts falling, the
overproduction and future investment plans are also given up. There is a steady decline in the
output, income, employment, prices and profits. The businessmen lose confidence and become
pessimistic (Negative). It reduces investment. The banks and the people try to get greater
liquidity, so credit also contracts. Expansion of business stops, stock market falls. Orders are
cancelled and people start losing their jobs. The increase in unemployment causes a sharp
decline in income and aggregate demand. Generally, recession lasts for a short period.
3. Depression Phase
When there is a continuous decrease of output, income, employment, prices and profits, there is a
fall in the standard of living and depression sets in.
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48. The features of depression are:
1. Fall in volume of output and trade.
2. Fall in income and rise in unemployment.
3. Decline in consumption and demand.
4. Fall in interest rate.
5. Deflation.
6. Contraction of bank credit.
7. Overall business pessimism.
8. Fall in MEC (Marginal efficiency of capital) and investment.
In depression, there is under-utilization of resources and fall in GNP (Gross National Product).
The aggregate economic activity is at the lowest, causing a decline in prices and profits until the
economy reaches its Trough (low point).
4. Recovery Phase
The turning point from depression to expansion is termed as Recovery or Revival Phase. During
the period of revival or recovery, there are expansions and rise in economic activities. When
demand starts rising, production increases and this causes an increase in investment. There is a
steady rise in output, income, employment, prices and profits. The businessmen gain confidence
and become optimistic (Positive). This increases investments. The stimulation of investment
brings about the revival or recovery of the economy. The banks expand credit, business
expansion takes place and stock markets are activated. There is an increase in employment,
production, income and aggregate demand, prices and profits start rising, and business expands.
Revival slowly emerges into prosperity, and the business cycle is repeated. Thus we see that,
during the expansionary or prosperity phase, there is inflation and during the contraction or
depression phase, there is a deflation.
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49. 3.20 THE PHILLIPS CURVE
In a 1958 article that was to become a frequently cited reference in the economics literature,
economist A.W. Phillips reported evidence of an inverse relationship between the rate of
increase in wages and the rate of unemployment. Comparing rates of increase in wages with
unemployment rates in Britain between 1861 and 1957, Phillips found that as the labor market
tightened, and the unemployment rate fell, money wages tended to rise more rapidly. Because
wage increases are closely correlated with price increases, which relationship was widely
interpreted as a trade-off between inflation and unemployment? The implication was that, given
a trade-off between inflation and unemployment, policymakers could "buy" a lower rate of
unemployment at the cost of a higher rate of inflation. The curve describing this trade-off
became known as the "Phillips curve."
A stable Phillips curve would mean that policymakers might choose one among several
combinations of inflation and unemployment rates that seemed to be most palatable and set that
as the goal of macroeconomic policy. The U.S. experience of the 1960s did little to disprove that
view. The theoretical explanation for the downward-sloping line describing the trade- off
between unemployment and inflation depends on the notion of excess demand. As long as
aggregate demand exceeds economic capacity, the unemployment rate will tend to fall, and vice
versa.
Similarly, demand in excess of supply will tend to push up both wages and prices, so that rising
prices tend to be correlated with falling unemployment. Similarly, an unexpected increase in the
rate of inflation would, temporarily, reduce the rate of increase in real wages and contribute to a
decrease in the unemployment rate. Again, as long as workers fail to notice the effects of rising
prices on their money wages, there is likely to be a drop in unemployment due to a fall in real
wages. But eventually they will adjust their wage demands to reflect the higher price level, or the
higher rate of inflation.
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50. This increase in real wage demands will tend to reverse the drop in the unemployment rate. In
the long run, the unemployment rate tends toward a level that represents equilibrium between the
supply of labor and demand for it. This level was dubbed the "natural" rate, and is the rate of
unemployment consistent with a stable rate of inflation. It is the level to which the
unemployment rate tends when the public is not fooled by inflation. Some economists prefer a
more clinical term, the "non-accelerating inflation rate of unemployment," or NAIRU. A higher
rate of inflation would not mean a permanent decline in the unemployment rate.
Eventually, other things being equal, expectations would adjust and the unemployment rate
would tend to return to its natural rate. If policy were to push unemployment below the natural
rate, the rate of inflation would wind up permanently higher after workers raised their
expectation of inflation, and there would be a new Phillips curve describing the trade-off
consistent with that higher expected rate of inflation.
Any short-term trade-off between inflation and unemployment would now involve higher rates
of inflation than before.
This process of shifting the trade-off could continue as long as
policymakers keep trying to push the unemployment rate below its natural level. The implication
of a constantly shifting Phillips curve is that in the long run there is no trade-off, and that the
long-run Phillips curve is vertical at the natural rate. Policymakers cannot expect to choose a
point on any one Phillips curve above, or below, the natural rate of unemployment and stay
there.
Page 50 of 67

51. 3.21 EXPLANATION OF PHILLIPS CURVE
The Phillips curve shows the relationship between unemployment and inflation in an economy.
Since its ‘discovery’ by British economist AW Phillips, it has become an essential tool to
analyze macro-economic policy.
Fig.3.2
Page 51 of 67

52. 3.22 MONETARIST VIEW OF THE PHILLIP CURVE
Fig.3.3
Monetarists argue that the Long Run AS curve is inelastic and therefore any increase in AD will
only lead to inflation in the long run. However in the short term M. Friedman stated there may be
a tradeoff between unemployment and inflation. If there is an increase in AD firms will increase
wages to encourage more workers to supply their labor. Workers believe they have higher real
wages and so are willing to supply more labor. This increase in the supply of labor leads to an
increase in output and therefore there will be a temporary fall in unemployment. Therefore there
will be a movement along the SR Phillips curve. However workers later realize inflation has
increased therefore they re-adjust their expectations of inflation, and realize the increase in
wages is only a nominal increase. Therefore workers don’t supply more labor and output returns
to the Long run equilibrium of Yf. Therefore in the long term output has stayed the same but
inflation has increased. Therefore the Long Run Phillips curve is inelastic because higher
inflation has not been accompanied by lower unemployment. Any reduction in unemployment
due to increased AD would only be temporary. Monetarists argue that Unemployment cannot be
altered by AD in the long run. But will remain at its Natural Rate which would be 5%.
Page 52 of 67

53. 3.23 STAGFLATION – AN OVERVIEW
In a Phillips phase, the inflation rate rises and unemployment falls. A stagflation phase is marked
by rising unemployment while inflation remains high. In a recovery phase, inflation and
unemployment both fall.
Fig.3.4
Page 53 of 67

54. 3.24 WHAT IS STAGFLATION AND WHY IS IT SO DANGEROUS?
Stagflation is a term that describes a "perfect storm" of economic bad news: high unemployment,
slow economic growth and high inflation. The term was born out of the prolonged economic
slump of the 1970s, when the United States experienced spiking inflation in the face of a
shrinking economy, something economists had previously thought to be impossible. The word
stagflation is a contraction of "stagnant" and "inflation." When the economy is stagnant, it means
that the gross domestic product (GDP) -- the standard measure of a nation's total economic
output is either growing at a very slow rate or shrinking.
The natural result of economic stagnation is increased unemployment. Businesses lay off
employees to save money, which in turn decreases the purchasing power of consumers, which
means less consumer spending and even slower economic growth. Economic slowdowns are a
normal part of the macroeconomic cycle [source: Samuelson]. When financial speculation gets
out of hand (as it did with the technology stocks of the late 1990s and the housing market of the
mid-2000s), the market needs to stabilize itself. This usually happens through a temporary, if
painful, recession. The prolonged period of slow economic growth is coupled with high rates of
inflation.
In a normal year, inflation might rise two or three percentage points. If the rate of inflation
begins to rise past 5 or even 10 percent, things can get hairy. This is why stagflation is so
dangerous. Imagine a scenario in which you have both a sinking economy and runaway inflation.
With high unemployment, consumers have less money to spend. Add inflation, and the money
they do have is worth less and less every day. If you're on a fixed income, inflation erodes the
value of your monthly check. And if you've managed to save some money, inflation eats away at
its value, too. Inflation is a real confidence killer in an already depressing economic environment
[source: Ryan]. Prior to the 1970s, economists thought it was impossible to have both a stagnant
economy and high inflation.
Page 54 of 67

55. According to the economic principles of John Maynard Keynes, an influential British economist,
inflation was a byproduct of economic growth. For Keynesians, it's all about supply and demand.
When demand is high as it is during a booming economy then prices go up. What the Keynesians
didn't realize was that there were other powerful economic forces that could throw inflation into
an upward spiral.
3.25 WHAT ARE THE CAUSES OF STAGFLATION?
Stagflation can be result of supply side shock. Imagine a situation where a country is already
suffering from stagnation and high unemployment. This country is also very big importer of oil.
Suddenly there is rise in the oil prices. Increase in oil prices govern corresponding rise in the
other commodity prices. Oil being the major commodity in most of the production activities,
any price rise in the oil increase the overall production cost. In order to cover for the rise in the
production cost, the manufacturing units need to increase the price of the commodities. Thus the
combined effect of stagnant economy and increase in the price of essential commodity lead to
stagflation. Stagflation can also be caused by mismanaged macroeconomic policies. Central
banks can increase money supply in order to provide spurt to the economy.
These actions are bound to increase the prices of commodities. These policies need to be
complemented by appropriate labor and goods policies. If there is mismatch between monetary
policies and labor & good policies, it may lead to decrease in production. If such a situation
continues for long time, then it may lead to stagflation. During the recession countries suffers
from reduced output in terms of GDP and increase in unemployment. The threat of stagflation
greatly increases during recession. According to standard monetary policy, the central bank
across the world lowers interest rates during a recession to encourage borrowing and spending.
The key to preventing stagflation is to avoid allowing too much money to enter the economy too
quickly.
Page 55 of 67

56. 3.26 HOW TO PREVENT STAGFLATION
Economist Milton Friedman was one of the first to predict the stagflation of the 1970s. Friedman
understood that the Federal Reserve wields incredible power to increase or decrease inflation in
the U.S. In Friedman's worldview, inflation happens when the Fed allows too much money to
circulate in the economy. His formula for inflation is simple: "Too much money chasing too few
goods." The dual mission of the Fed is to keep prices stable and maximize employment [source:
Hobson]. The strategy for achieving this mission is called monetary policy. Modern monetary
policy is heavily influenced by Friedman's theories. When the economy is growing, the Fed
raises interest rates to limit the amount of money in circulation. When the economy slows, the
Fed lowers interest rates to encourage borrowing and increase the amount of money in
circulation. The goal is to strike a precarious balance where the economy grows at a healthy rate
without allowing inflation to get out of control.
In the 1960s, in an effort to maximize employment at all costs, the Fed lowered interest rates and
flooded the economy with money. This led to increased demand for goods and services and
rising prices. When it was clear in the 1970s that inflation was spiraling out of control, the Fed
and the federal government took the erroneous approach of pumping more money into the
system even as real economic output sagged. This fit Friedman's formula for inflation: too much
money chasing too few goods. It wasn't until 1979, with the appointment of Fed chairman Paul
Volcker, that the Fed put Friedman's monetary policy theory into practice [source: Orphanides].
Volcker raised interest rates, choking off the flow of money into the economy. It meant high
unemployment and a significant recession in the early 1980s, but inflation returned to normal
levels and the economy eventually stabilized.
The threat of stagflation is greatly increased during a recession, when GDP is slumping and
unemployment is on the rise. According to standard monetary policy, the Fed lowers interest
rates during a recession to encourage borrowing and spending. The key to preventing stagflation
is to avoid allowing too much money to enter the economy too quickly. To successfully avoid
stagflation during a recession, Fed economists need to accurately predict both the short- and
long-term performance of the economy. They have the difficult job of identifying the turning
Page 56 of 67

57. point when the country emerges from recession and slowly pulling money out of circulation.
This requires impeccable timing. If the Fed raises interest rates too soon, it could kick the legs
out from under the restarting economy. If it waits too long, the economy can become overheated
with extra cash, causing prices to rise and inflation to soar [source: Gogoll].4
4
http://www.businessdictionary.com/definition/unemployment.html#ixzz2DghsULpc
http://economics.about.com/od/economicsglossary/g/unemployment.htm
www.tutor2u.net/blog/.../as-macro-key-term-frictional-unemployment
http://www.buzzle.com/articles/frictional-unemployment.html
www.brighthub.com › Business › Human Resources › Labor Law
http://www.wisegeek.com/what-is-cyclical-unemployment.htm
http://www.fxwords.com/c/cyclical-unemployment.html
http://money.howstuffworks.com/recession-and-depression1.htm
http://www.cbsnews.com/8301-505123_162-39740923/nobel-prize-winners-how-we-can-reduce-unemployment/
http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=structural+unemployment
www.economicshelp.org/.../policies-for-reducing-un... - United Kingdom
http://toostep.com/insight/unemployment-in-india
http://kalyan-city.blogspot.com/2011/06/4-phases-of-business-cycle-in-economics.html
http://www.snpnifty.com/INFLATION_AND_UNEMPLOYMENT.html
http://economicsonline.co.uk/Global_economics/Phillips_curve.html
economicsonline.co.uk/Global_economics/Phillips_curve.html
http://www.economicshelp.org/blog/1364/economics/phillips-curve-explained/
http://en.wikipedia.org/wiki/Disinflation
http://www.business-standard.com/india/news/stagflation-not-yet-indian-economists-/478615/
http://www.web-books.com/eLibrary/NC/B0/B62/079MB62.html
http://insearchofblackswan.blogspot.com/2012/02/chart-of-day-unemployment-rate-in-bric.html
Page 57 of 67

58. 4 DATA ANALYSIS
Table: 4.1
CPI Inflation Rates: 2002-2012
Country
India
2002
8.8
2003
9.5
2004
9.2
2005
8.9
2006
7.8
2007
7.2
2008
6.8
2009
10.7
2010
10.8
2011
9.8
Source: CIA World Fact book - Unless otherwise noted, information in this page is accurate as of January 1, 2011
CPI Inflation Rates Graph (2002-2012)
Fig.4.1
Page 58 of 67

59. The inflation rate in India is based on the Wholesale Price Index (WPI). In India, the Wholesale
Price Index is more closely observed than the Consumer Price Index (CPI), as it includes a
higher number of products. Manufactured products have a weight of about 65 percent in the WPI
basket. The ambiguity in global oil markets has worsened inflation edginess in India, which
imports three-quarters of its oil. India is Asia’s third largest economy with a $1.3 trillion
economy.
Table: 4.2
Yearly Wholesale Price Index - Base Year 2004-05 = 100
Year
2011
2010
2009
2008
2007
2006
2005
Index
153.35
140.08
127.86
124.92
114.94
109.59
103.37
WPI Inflation Rates Graph (2010-2012)
Index
180
160
140
120
100
Index
80
60
40
20
0
2005
2006
2007
2008
2009
2010
2011
Fig.4.2
Page 59 of 67

60. Table: 4.3
Unemployment rate (%)
Country
India
2002
2003
8.8
2004
9.5
2005
9.2
2006
8.9
2007
7.8
2008
7.2
2009
6.8
10.7
2010
2011
10.8
9.8
Unemployment rate (%) Graph (2002-2011)
Unemployment Rate (%)
12
10
8
6
Unemployment Rate (%)
4
2
0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Fig.4.3
Page 60 of 67

61. Table 4.4
India Economic Forecast
%
Unemployment Rate
Consumer Price Inflation
2012
9.80%
8.50%
2013
9.60%
8.40%
2014
9.30%
7.90%
2015
8.90%
7.50%
2016
9.90%
6.70%
Source: Economist Intelligence Unit as of Dec 1st 2011
India Economic Forecast Graph (2012-2016)
12.00%
10.00%
8.00%
Unemployment Rate
6.00%
Consumer Price Inflation
4.00%
2.00%
0.00%
2012
2013
2014
2015
2016
Fig.4.45
5
http://www.indexmundi.com/g/g.aspx?c=in&v=71
http://www.theteamwork.com/articles/2016-2101-indian-government-current-monthly-annual-inflation-rate.html
http://www.indexmundi.com/g/g.aspx?c=in&v=74
http://www.ijeronline.com/documents/volumes/Vol%203%20Iss%204/ijerv3i4JuAu2012(2).pdf
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