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Descriptive Analysis of Inflation and Unemployment in Indian Econonmy
 

Descriptive Analysis of Inflation and Unemployment in Indian Econonmy

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    Descriptive Analysis of Inflation and Unemployment in Indian Econonmy Descriptive Analysis of Inflation and Unemployment in Indian Econonmy Document Transcript

    • 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 Page 1 of 67
    • 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 Page 2 of 67
    • 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. Page 3 of 67
    • 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 Page 4 of 67
    • 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 Page 5 of 67
    • 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 Page 6 of 67
    • 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. Page 7 of 67
    • 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 Page 8 of 67
    • 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 Page 9 of 67
    • 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. Page 10 of 67
    • 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. Page 11 of 67
    • 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 Page 12 of 67
    • 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. Page 13 of 67
    • 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. Page 14 of 67
    • 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 Page 15 of 67
    • 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). Page 16 of 67
    • 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. Page 17 of 67
    • 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 Page 18 of 67
    • 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 Page 19 of 67
    • 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. Page 20 of 67
    • 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 Page 21 of 67
    • 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. Page 22 of 67
    • 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. Page 23 of 67
    • 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. Page 24 of 67
    • 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. Page 25 of 67
    • 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. Page 26 of 67
    • 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). Page 27 of 67
    • 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 Page 28 of 67
    • 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. Page 29 of 67
    • 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 Page 30 of 67
    • 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 Page 31 of 67
    • 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. Page 32 of 67
    • 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. Page 33 of 67
    • 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. Page 34 of 67
    • 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. Page 35 of 67
    • 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 Page 36 of 67
    • 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. Page 37 of 67
    • 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 Page 38 of 67
    • 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 Page 39 of 67
    • (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. Page 40 of 67
    • 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. Page 41 of 67
    • 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. Page 42 of 67
    • 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. Page 43 of 67
    • 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 Page 44 of 67
    • 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). Page 45 of 67
    • 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:- Page 46 of 67
    • 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. Page 47 of 67
    • 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. Page 48 of 67
    • 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. Page 49 of 67
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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 Page 61 of 67
    • 5 RESULTS AND CONCLUSION It can be seen from Table 4.1 (CPI Inflation Rates - 2002 to 2012), the inflation rates during the year 2002 and 2005 is consistent. There is a decline in inflation rate from the year 2005 to 2008 and again there is a steep increase in inflation from 2008 to 2009. Again from 2009 to 2011 inflation has stayed at the same level. From Table 4.2 Yearly Wholesale Price Index - Base Year 2004-2005 (2005 to 2011), it can be seen that WPI has been steadily increasing. 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. Table 4.3 Unemployment rate (%) indicates that during the years 2002 to 2005, the unemployment rate is varying from 8.5 to 9.5 and there is a steep decline from 2005 to 2008. From 2008 to 2010, unemployment rates have drastically increased to double digit numbers and subsequently in 2011 the unemployment rate has remained close to 10 percentage. 2002 to 2005 when the CPI rate was more or less consistent, the unemployment rate was also equally consistent. 2005 to 2008, CPI rate was declining and unemployment rate was also declining from 2008 to 2011, CPI inflation rate has increased and unemployment rate has also drastically increased. From the above, it can be inferred that inflation rate and unemployment rate is going hand in hand in the Indian scenario. It is seen that WPI has been steadily increasing since 2005 but the unemployment rate showed a decline between 2005 and 2008. So a particular trend is not observed during 2005 and 2008 between the WPI inflation rate and the unemployment rate in Indian economy. But from 2008 to 2011 both WPI and unemployment rate is steadily increasing. Page 62 of 67
    • The Economist Forecast graph for India Fig.4.4 (2012 - 2016) again shows a parallel connection between CPI and Unemployment till 2015. But it shows a tradeoff between CPI and unemployment for the year 2016 only. So when the CPI is reducing there is a simultaneous increase in unemployment rate predicted for the year 2016. On the basis of the WPI data that has been analyzed it can be said that in India the rate of inflation has a positive impact on unemployment rates. That is unemployment is still on the rise in the Indian economy in the past decade till present. Page 63 of 67
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