Relationship Between Inflation and Unemployment in India

Economic and Social Environment

Q. There is a strong relationship between unemployment and inflation. India's situation is different. Discuss. A. Unemployment Rate The labor force is defined as the number of people employed plus the number unemployed but seeking work. The unemployment level is defined as the labor force minus the number of people currently employed. The unemployment rate is defined as the level of unemployment divided by the labor force. Inflation Rate Definition Inflation refers to a general rise in prices measured against a standard level of purchasing power. Previously the term was used to refer to an increase in the money supply, which is now referred to as expansionary monetary policy or monetary inflation. Inflation is measured by comparing two sets of goods at two points in time, and computing the increase in cost not reflected by an increase in quality. The most well known are the CPI which measures consumer prices, and the GDP deflator, which measures inflation in the whole of the domestic economy. Inflation and unemployment Inflation and unemployment go hand in hand. For every country, maintaining a low unemployment rate is the main objective. It is usually believed that inflation and unemployment are inversely proportional. There are many economists, who hold the opinion that low rate of unemployment together with low inflation rate may be a source of concern. Both low inflation rate and low unemployment rate, may be hypothetical. In real practice, this rarely happens. If a particular country has full employment, it can be said to have minimum rate of unemployment. If a nation maintains a minimum rate of unemployment in a condition when inflation rate is stable, it is said to follow the natural rate of unemployment. In other words, the natural rate of unemployment is the minimum rate of unemployment, which can be sustained. The Philips Curve The Philips Curve, named after William Philips suggested the relationship between inflation and unemployment. The Philips curve shows how inflation and unemployment are related. He suggested that if rate of inflation is high, rate of unemployment is low. On the other hand, if the rate of inflation is low, unemployment rate is high. If rate of inflation increases suddenly, it temporarily reduces, the rate of increase in the wages. Consequently, unemployment rate decreases. If the workers are able to cope with the increase in inflation, unemployment rate is also less. However, when they do realize that in order to compensate for the increase in price of commodities, the wages ought to be increased, unemployment may rise to a

Economic and Social Environment considerable extent. This increase in the demand of wages, has a tendency to reverse the unemployment mployment curve to some extent (unemployment rises). If the rate of inflation is very high, it does not mean that, there will be a permanent decrease in the rate of unemployment. As a rule, rate of inflation and unemployment adjust themselves to attain the equilibrium state, which is known as the natural rate of unemployment state, effortlessly.

Friedman-Phelps interpreted Phillips Curve with the following conclusions The trade-off is short-run. Different Phillips curves exist for different inflation rates Changes in inflation expectations shift the short short-run Phillips curve “Stabilization” policy increases the inflation rate and variability. The changes in govt policies had an impact the Phillips curve, an example below illustrates this

Economic and Social Environment Unemployment If the Govt. INCREASES the benefits they pay to the unemployed/underemployed in general this produces a higher level of FRICTIONAL unemployment. People tend to stay unemployed for longer periods of time because the replacement income they receive from the govt. is closer to their lost income…In other words, the incentive to look for a Job is diminished and the tendency to stay unemployed increases.. The LONG RUN PHILLIPS CURVE SHIFTS TO THE RIGHT

If the Govt. DECREASES the benefits they pay to the unemployed/underemployed in general this produces a lower level of FRICTIONAL unemployment. People tend to stay unemployed for shorter periods of time because the replacement income they receive from the govt. is much LESS then their original income…In other words, the incentive to look for a job is INCREASES and the tendency to stay unemployed DECREASES... The LONG RUN PHILLIPS CURVE SHIFTS TO THE LEFT

Some economic studies suggests that the Phillips curve is nonexistent in India. This study finds that supply shocks, namely droughts and oil crises, and the liberalization-policy shock of the early 1990s are the main reasons for the absence of the Phillips curve in India Inflation and Unemployment rates of Major economies

Inflation and Unemployment in India

Economic and Social Environment

Stagflation Stagflation is an economic situation where the growth rate slows down, unemployment levels remain steadily high & inflation also stays high. Stagflation, a concept which did not gain acceptance till the 1960s, is described as a situation in the economy where the growth rate slows down, the level of unemployment remains steadily high and yet the inflation or price level remains high at the same time. At the first instance, high inflatio inflation n and unemployment or slower growth seem like opposites and mutually exclusive. What causes stagflation? The major reasons for stagflation, whenever it has occurred in history, have been been-supply shocks or shortages due to unforeseen reasons which push up p prices rices of essential commodities, causing an inflationary situation and at the same time pushing up production costs, as it happened in 1970s in the US. The other reason is failure of the monetary authority to control excessive growth of money supply in the economy and excessive regulation of goods and labour markets by the government. For example, in the 1970s, a similar situation occurred during the global stagflation, where it began with a huge rise in oil prices, but then continued as central banks used simulative monetary policy to counteract the resulting recession, causing a runaway wage wage-price spiral. Is India on the brink of stagflation? Though the central bank and the Centre have had to revise their growth targets, which have taken a hit due to persistently high double-digit digit inflation, economists are far from assuming a stagflation like situation in India just as yet. The Reserve Bank of India deputy governor Subir Gokarn has said headline inflation numbers are much higher than the appropriate rate of inflation that will moderate growth but will keep it steady, which according to RBI's estimates, should be between 5% and 6%. At the latest policy meeting on 16 September, the Reserve Bank again hiked rates by another 25 basis points with the goal of licking king inflation. But the RBI ought to realize that at some point high interest rates will lead to high inflation. Also the time has come for the Indian government to take some action as the RBI alone cannot solve the multi multi-year, fiscal deficit-triggered problem blem of inflation.

Economic and Social Environment High inflation and a slowdown create a vicious stagflationary circle that's difficult to break. Corporate are already complaining that the continued increase in interest rates is slowing growth. Slow growth negatively affects the supply of goods and services. This in turn pushes the prices up, leaving inflation stubbornly high. In India the interest rates of savings have dramatically gone up over the past several months. This by itself increases money supply by putting more cash in the hands of individuals increasing demand for goods and services, which pushes up prices. In a scenario where output of goods and services slow down, higher demand only increases inflation. For ages RBI has been trying achieve price stability by targeting demand. It does this by manipulating money supply. Hence to increase demand it reduces interest rates and increases money supply.

References http://www.tradingeconomics.com/unemployment-rates-list-by-country http://www.forbes.com/sites/advisor/2011/08/26/stagflation-is-knocking-on-the-door/ http://faculty-web.at.northwestern.edu/economics/gordon/ARNfull.pdf http://www.indianexpress.com/news/cut-policy-rates-to-reduce-inflation-basu/849484/0 http://www.thehindubusinessline.com/opinion/columns/p-vndiresan/article2479811.ece?homepage=true