Chapter 10 & 11

Price StabilityTypes of price rise-1. Creeping-2 percent annually2. Walking-5 percent annually3. Running-10 percent annually4. Galloping or Hyper Inflation-more than 10 percent annuallyOn the basis of time-1. Peace time2. War time3. Post war timeMain causes 1. Demand Pull2. Cost-push-wage push, profit push, material push

Causes Factors causing increase in demand1. Increase in money supply2. Increase in government expenditure3. Increase in private expenditure4. Increase in exports5. Increase in population6. Paying off debts7. Black moneyFactors causing decease in supply1. Scarcity of factors of production2. Hoarding3. Trade union activities

4 .Natural calamities5. Increase in exports6. Law of diminishing returns7.War8.International CausesEffects of Price Rise1. Effects on Production2. Effects on Distribution3. Non-Economic Consequencesa. Social effectsb. Moral effectsc. Political effects

Control of Price Instability

Monetary

Fiscal

Direct Controls

Demand Pull Inflation

The Monetarist Theory

D

D1

D2

Output

Pric

e Le

vel

P

P1

P2

M

S

Keynesian Theory

d d1d2

d3

d4

s

s

P1

P2

P3

Output m m1 m3 m4

Cost Push Inflation

D

S

S

S1

P

P1E

E1

MM1 Output

Price Level

According to Keynes, inflationary gap exists when, at full employment income level, aggregate demand exceeds supply. This means that due to increase in investment and government expenditure, the money income increases, but production does not increase because of the limitations of productive capacity. As a result, an inflationary gap comes to exist, causing the prices to rise. The prices continue to rise so long as the inflationary gap exists.

INFLATIONARY GAP

Y=C+I+G is the equilibrium line which shows the equality of total income and total expenditure. The initial equilibrium of the economy is at point Eo which represents full employment income OYo.

When expenditure increases from C+I+G to C’+I’+G’, the new equilibrium will be at E1, representing higher money income OY1. The available output is EoYo or OYo which is less than the money income E1Y1 or OY1 by the vertical distance E1G. This is Inflationary Gap.

C+I+G

C’+I’+G’

Y=C+I+G

E0

E1

G

Yo Y1

INCOME

EX

PE

ND

ITU

RE

O

Inflationary and Deflationary Gaps

Inflationary gap occurs when ADexceeds AS at full employment level of output. In this case, moneyrises to a higher equilibrium, butreal income being at full employmentoutput level remains unchanged. As aresult there is an upward rise in pricesbecause the consumers compete for

limited supply of output and bid prices up.

Deflationary gap prevails when AD is less than AS at full employment level of output. Income equilibrium occurs while resources are unemployed.

EX

PE

ND

ITU

RE

(C+

I+G

)E

XP

EN

DIT

UR

E(C

+I+

G)

Yf

Yf

YO

YOO

E

B

A

B

AE

O

AS orY=C+I+G

AD orC+I+G

Inflationarygap

Deflationarygap

AS orY=C+I+G

AD orC+I+G

Income (Y)

Income (Y)

Less Investment Expenditure

Less Aggregate Demand

Causes of Deflation

Less Consumption Expenditure

Low MEC High Rate of Interest

High Liquidity Preference Less Supply of Money

Phillips CurveIn 1958, A.W.Phillips presented an empirical theory of inflation commonly known as Phillips curve

hypothesis. The Phillips curve expresses empirical wage-price-employment relationship. On the basis of the data of the UK for the period between 1861-1957, Phillips found that there existed a stable, inverse and non-linear relationship between the rate of change in money wage (W) and unemployment rate (U). When unemployment is low, wages will rise; when unemployment is high, wages will tend to fall but slowly because of the downward rigidity of wage rates.

Wage InflationRate

Wage Inflation

U3 U2 U1

W3

W2

W1

w

w

U

U0

Inflation and Unemployment using AS/AD

Inflation

Real National Income

AD1

AS1

2%

U = 4%

Assume the economy has an inflation rate of 2% and a level of national income giving an unemployment rate of 4%. AD rises for some reason.

AD2

U = 3%

3.75%

The rise in AD leads to a fall in unemployment but inflationary pressures push inflation up to 3.75%. Producers try to expand output but at increased cost – employing more expensive capital, paying workers more to do work etc. Increased cost results in a shift in AS to the left – workers start to be laid off.

AS2

4.0%

The short run fall in unemployment is only temporary; as AS shifts, unemployment will start to rise again and the economy will end up in the long run in a position with unemployment at 4% but with higher inflation. Expansionary fiscal or monetary policy will only lead to reductions in unemployment in the short run. In the long run unemployment will return to its natural rate. Attempts to reduce unemployment below the natural rate will be inflationary.

The Philips Curve

The Phillips Curve

• 1958 – Professor A.W. Phillips• Expressed a statistical relationship between the rate

of growth of money wages and unemployment from 1861 – 1957

• Rate of growth of money wages linked to inflationary pressure

• Led to a theory expressing a trade-off between inflation and unemployment

The Phillips CurveWage growth % (Inflation)

Unemployment (%)

The Phillips Curve shows an inverse relationship between inflation and unemployment. It suggested that if governments wanted to reduce unemployment it had to accept higher inflation as a trade-off.

Money illusion – wage rates rising but individuals not factoring in inflation on real wage rates.

1.5%

6%4%

2.5%

PC1

The Phillips Curve

• Problems:• 1970s – Inflation

and unemployment rising at the same time – stagflation

• Phillips Curve redundant?• Or was it moving?

The Phillips CurveWage growth % (Inflation)

Unemployment (%)

An inward shift of the Phillips Curve would result in lower unemployment levels associated with higher inflation.

1.5%

6%4%PC1

3.0%

PC2

The Phillips CurveInflation

Unemployment

Long Run PC

PC1

PC2PC3

Assume the economy starts with an inflation rate of 1% but very high unemployment at 7%. Government takes measures to reduce unemployment by an expansionary fiscal policy that pushes AD to the right (see the AD/AS diagram on slide 15)

7%

2.0%

1.0%

There is a short term fall in unemployment but at a cost of higher inflation. Individuals now base their wage negotiations on expectations of higher inflation in the next period. If higher wages are granted then firms costs rise – they start to shed labour and unemployment creeps back up to 7% again.

3.0%

To counter the rise in unemployment, government once again injects resources into the economy – the result is a short-term fall in unemployment but higher inflation. This higher inflation fuels further expectation of higher inflation and so the process continues. The long run Phillips Curve is vertical at the natural rate of unemployment. This is how economists have explained the movements in the Phillips Curve and it is termed the Expectations Augmented Phillips Curve.

The Phillips Curve

• To reduce unemployment to below the natural rate would necessitate:

1. Influencing expectations – persuading individuals that inflation was going to fall

2. Boosting the supply side of the economy - increase capacity

• Whenever unemployment is low, inflation tends to be high. Whenever unemployment is high, inflation tends to be low. This inverse relationship between inflation and unemployment is called the Phillips curve.

• The Phillips curve is a relative relationship. Unemployment is considered low or high relative to the so-called natural rate of unemployment. Inflation is considered low or high relative to the expected rate of inflation.

• The definitions of the natural rate of unemployment and expected inflation are nearly circular. What is the natural rate? It is the rate of unemployment at which inflation is equal to expected inflation. What is expected inflation? It is the inflation rate that prevails when unemployment is equal to its natural rate.

The Lucas AS functionIn the New Classical approach, a given SRAS curve applies only to unexpected

shifts in AD. Suppose there is a shift in aggregate demand from AD0 to AD1. If the shift is unexpected, the economy will move from the initial position at point A to point B, at the intersection of SRASo and AD1 . However, if the shift in AD is expected, agents will negotiate higher wages immediately on the basis of this expectation, and the SRAS curve will shift up to SRAS1. The price level will go straight from P0 to P1 and the economy will move from A to C, with no increase in GDP.

Policy ineffectiveness follows from the sameanalysis. Any predictable change in monetaryand fiscal policy causing a change in AD fromAdo to AD1, will lead to a rise in prices from Po to P1 and will have no effect on real GDP.An unexpected policy change of the same magnitude however, would take the economyfrom point A to B in the short run, and to C onlyin the long run.

LRASSRAS1

SRAS0

AD1

AD0

cB

A

Y* y1

P1

P0

Real GDP

Price Level

Inflation in India

• WPI• CPI• Inflation in an emerging economy• Deflation• Weekly and monthly assessment of Inflation

rate

IDENTIFYING UNEMPLOYMENT

• Categories of Unemployment• The problem of unemployment is usually divided

into two categories.• The long-run problem and the short-run problem:

• The natural rate of unemployment• The cyclical rate of unemployment

• Natural Rate of Unemployment• The natural rate of unemployment is

unemployment that does not go away on its own even in the long run.

• It is the amount of unemployment that the economy normally experiences.

• Cyclical Unemployment• Cyclical unemployment refers to the year-to-

year fluctuations in unemployment around its natural rate.

• It is associated with short-term ups and downs of the business cycle.

• Frictional unemployment refers to the unemployment that results from the time that it takes to match workers with jobs. In other words, it takes time for workers to search for the jobs that best suit their tastes and skills.

• Structural unemployment is the unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one.

• The World Bank classifies its anti unemployment and poverty activities into three groups:

a. Fostering opportunity – through well-functioning and internationally open markets, and investments in infrastructure and education.

b. Facilitating empowerment, which amounts to including people in the decision-making process. This requires government accountability, a strong media, local organizational capacity, and mechanisms for participation in making decisions.

c. Addressing income security, which tackles the problem of vulnerability.

Overview of Unemployment in India

• Economic reforms may have given a boost to industrial productivity and brought in foreign investment in capital intensive areas. But the boom has not created jobs. This was not unexpected.

• Five-Year Plan projects has always fallen short of target in the past, and few believe that the current Plan will be able to meet its target.

• India's labour force is growing at a rate of 2.5 per cent annually, but employment is growing at only 2.3 per cent. Thus, the country is faced with the challenge of not only absorbing new entrants to the job market (estimated at seven million people every year), but also clearing the backlog.

• Sixty per cent of India's workforce is self-employed, many of whom remain very poor. Nearly 30 per cent are casual workers (i.e. they work only when they are able to get jobs and remain unpaid for the rest of the days). Only about 10 per cent are regular employees, of which two-fifths are employed by the public sector.

• More than 90 per cent of the labour force is employed in the "unorganised sector", i.e. sectors which don't provide with the social security and other benefits of employment in the "organised sector."

• In the rural areas, agricultural workers form the bulk of the unorganised sector. In urban India, contract and sub-contract as well as migratory agricultural labourers make up most of the unorganised labour force.

• Unorganised sector is made up of jobs in which the Minimum Wage Act is either not, or only marginally, implemented. The absence of unions in the unorganised sector does not provide any opportunity for collective bargaining.

• Over 70 per cent of the labour force in all sector combined (organised and unorganised) is either illiterate or educated below the primary level.

Sector-wise absorption of labour Agriculture 62 per cent Manufacturing & construction 16 per cent Services 10 per cent Sundry / miscellaneous jobs 12 per cent

• Table 1 : Age structure of population: 1997-2002 Age-group 1997 2002 0 – 14 37.23% 33.59% 15 - 59 56.07% 59.41% 60+ 6.70% 7.00%

Factors why unemployment is higher in India

The higher unemployment rate in India compared to West is due to small wrong ADMINISTRATIVE decisions that India's govts/citizens have taken in past years, or due to several right decisions they DID NOT take. The cumulative effect of these wrong administrative decisions is that we have chronically high unemployment, less growth etc.

Following are the main reasons why India has been having higher unemployment than West : The administration/courts in West create less obstacles to starting, running and closing a business/industry. Easy exit policies are necessary, as unless a business is closed, the resources like land, capital, machineries etc it owns cannot be sold or transferred to another business and hence starting another business will become expensive and difficult. In India, due to lack of Jury System against officers, the officers find it very easy to create obstacles in the path of small/medium industrialists etc. This has hampered the progress.

Lawlessness/corruption : In a large part of India, there is utter lawlessness and high corruption. Due to lawlessness, perpetual violence threat of extortion and kidnapping and rampant corruption in officers/judges, the small/middle level industrialists keep away. As a result, even large industrialists, who need a number of small/large industrialists to provide goods/services etc, do not go there. Hence high unemployment in those areas.

High stamp duty : The transfer duty of 12% on land/building sale drastically reduces liquidity in land/building market. The liquidity of land/building market is crucial to starting new industries and closing existing loss-making industries. The illiquidity in land/business market stifles industry and thus employment.

Lack of wealth tax : Due to lack of wealth tax, there is NO cost in hoarding land/building in India. As a result, lot of wealthy individuals merely keep hoarding land and buildings in large amount. This creates an artificial scarcity of land/building in crowded cities. This stifles industries and increases unemployment. While most Western countries have wealth tax due to which wealth hoarding is less.

Regressive taxes : The regressive taxes, like taxes on movie tickets, tobacco, sugar, cloth, liquor, edible oil, crude oil etc depletes the disposable incomes of poor. As a result, the poor in India have less money to spend, and so they buy fewer goods. This will decrease the sales, and thus reduce employment.

The currency system in India enables RBI-directors etc to deflate the currency i.e. rupee at the rate of 10% to 14% a year. This raises the cost of production, and puts an undue pressure on businesses and industrialists. As a result, unemployment increases.

The currency system in India enables RBI-directors etc to deflate the currency i.e. rupee at the rate of 10% to 14% a year. This raises the cost of production, and puts an undue pressure on businesses and industrialists. As a result, unemployment increases.

High cost of telecommunications: Due to defunctness in telecom regulation. the cost of phone calls (as a % of per capita GDP) is much higher in India. A low cost, and less sophisticated, telephony is possible in India, but due to defunct TRAI, does NOT materialize. And so the service providers have to depend to imported machineries, which increases the cost (as % of per-capita income). So cost of telephony remains higher in India compared to West. This reduces employment opportunities.

Defunct rental laws : Since rent laws are defunct, a large number of building owners hesitate in renting the apartments. This increases the cost of starting a new business. Hence lesser growth in employment opportunities.

High cost and poor quality of electricity : Given the voltage fluctuations, load shedding etc India has poor quality of electricity compared to West. And this is due to administrative problems, NOT lack of natural resources. The cost of fuel is same all across the world, but due to low competitiveness in electricity generation, transmission etc, the staff of the generation/transmission companies etc manage to get away with much higher salaries compared to per-capita income of an average Indian. This results into higher cost of electricity power. This in turn reduces industrial growth and increases unemployment.

POLICIES TO REDUCE UNEMPLOYMENT A. Reducing Cyclical Unemployment 1. Most economists believe that an

increase in cyclical unemployment is caused by a decrease in aggregate demand. 2. If wages and other input prices are "sticky," the economy can experience relatively long periods of cyclical unemployment and policies will be needed to reduce the unemployment. 3. Stabilization policies, government policies intended to maintain full employment and a reasonably stable price level, can be used. a. Expansionary fiscal and monetary policies can be used. 4. There is a tradeoff between reducing unemployment and increasing the price level.

If the economy is at full employment, expansionary policies will simply increase the price level and leave output unchanged. 5. Despite the use of stabilization policies, we still observe cyclical movements in the unemployment rate and price level.

These fluctuations occur because it is difficult to know how much to change variables such as government spending when using stabilization policy and because it is difficult to use stabilization policy in a timely manner.

B. Reducing Structural Unemployment 1. Policy suggestions to reduce structural

unemployment include providing government training programs to the structurally unemployed, paying subsidies to firms that provide training to displaced workers, helping the structurally unemployed to relocate to areas where jobs exist, and inducing prospective workers to continue or resume their education.

C. Reducing Frictional Unemployment 1. Policy suggestions to reduce frictional

unemployment include establishing a computerized national job bank that would provide job seekers and prospective employers with better information and implementing apprenticeship programs similar to those used in Austria and Germany.