Macroeconomics 1

INFLATION

According to the US economist Milton Friedman” Inflation is everywhere and always a monetary
phenomenon.” It is true that a temporary burst of inflation may or may not be a monetary
phenomenon; but a sustained inflation is necessarily a monetary phenomenon. If a rise in price is to
continue, it must be accompanied by continuing increases in the money supply or decrease in money
demand. This is true regardless of the cause that set the rise in prices in motion.

Contractionary fiscal and monetary policies should be adopted to control inflation

1. Tightening the amount of money allowed into the market.

2. Raising the amount of reserves, banks need to keep on hand.
3. Raising the bank rate.

But, these measures will reduce the output and increase unemployment also. We know that inflation
and unemployment is closely related, at least in the short term as shown in the Philips curve. So,
attempts to reduce inflation by applying tight monetary policies will lead to increase in the
unemployment. Therefore, we must walk a tightrope with inflation on one side and unemployment on
the other.

According to the modern theory of inflation 1 , in the long run the Philips curve is vertical, not
downward sloping. This approach implies that in the long run there is a minimum unemployment rate
that is consistent with steady inflation. This is called non accelerating inflation rate of unemployment
or NAIRU. The NAIRU is the lowest unemployment rate that can be sustained without upward
pressure on inflation. It represents the level of unemployment at which labor and product markets are
in inflationary balance.

1
Samuelson and Nordhaus,”The Economic Impact of Inflation”, Economics, 2005, pp.682-684.

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 Macroeconomics 2

So, we should try to lower the NAIRU- which will act as the best solution to the problem of inflation.
The following measures should be taken in this direction.

Stabilization policies to control inflation:

1. Labor market services should be improved through providing better information. It can reduce the
amount of frictional and structural unemployment.

2. Training programs for the unskilled or semiskilled workers; to train them for jobs in growing
sectors.

3. There should be greater incentives for the workers to work.

In summation, excessive money growth is the cause of inflation and a slower rate of money growth is
the solution of the problem. Stabilization can be attained by following tighter monetary policy as well
as lowering the NAIRU.

DEFLATION

Historical experiences and macroeconomic analysis suggest that deflation can cause serious
macroeconomic difficulties. Deflation may lead to a situation where monetary policy becomes
impotent. For example, at the end of the 1990s Japan entered a period of sustained deflation due to
tremendous fall in asset prices. The US also faced deflation in late 200 and early 2003, as short term
interest rates fell to their lowest point in half a century.

Stabilization policies to control deflation

1. Fiscal policy can be used to control deflation. A fiscal stimulus to the economy will increase
aggregate demand. By increasing the money supply, we can cause the inflation rate to rise, so we can
avoid deflation.

2. By influencing interest rates we can avoid deflation. By reducing interest rates, we can inject more
money in the system. As a result, consumer spending will be increased.

But if interest rates are too low, this method of controlling deflation is no longer an option, as
currently in Japan where interest rates are practically zero. Since the lower limit on nominal interest
rate is zero, but real interest rates can still be too high to stimulate the economy. For example, if the
nominal interest rate is ¼ % and prices are falling at 3 ¾% per year, then the real interest rate is 4%
per year. At this point, even if the central bank lowers the interest rate to zero; real interest rates
would still be 3 ¾% per year. So the central bank can no longer lower short term interest rates. This
situation is known as liquidity trap, when the central bank runs out of ammunition.

So, we need to carefully exercise these options, otherwise the economy could face the liquidity trap.

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 Macroeconomics 3

RECESSION

In macroeconomics, a recession is “a decline in any country's gross domestic product (GDP), or

negative real economic growth, for two or more successive quarters of a year ”. However, in addition
to GDP some economists also give weight to personal income, the national employment rate, sales in
manufacturing and trade, and industrial production.

Since it is unhealthy for a nation to be in recession, action should be taken to expand the economy
again. Market forces alone can’t provide the solution to the recession; some fiscal and monetary
policies are required to pull the economy out of recession.

Stabilization policies to control recession

1. Tax cuts – It will give people more money, which may make them more likely to buy things, which
increases demand.

2. Increasing government spending -Government spending can be increased to create new jobs. It will
increase demand for labor, which can lower the unemployment rate.

3. Lowering interest rates – It will encourage consumer spending, which will eventually boost the
overall health of the economy.

4. Reducing cash reserve ratio - If banks don't have to keep as high a percentage of their assets in
reserves, they have more accessible money. This might lead them to offer more attractive loans to
their customers, which can help boost economic growth.

But, all these policies should be implemented carefully. The monetary policy is a double-edged sword.
While it can be used to nudge the economy out of recession, it can also make things a lot worse. The
above mentioned policies to check recession might cause inflation also. So, we need to be extremely
careful in implementing monetary policy changes in order to avoid economic catastrophe.

STAGFLATION

Stagflation is when the economy experiences slow GDP growth (stagnation) with high inflation and
high level of unemployment. This occurred in the 1970's in many countries. When the economy is
working normally, slow economic growth reduces demand, which keeps prices low, preventing
inflation. Stagflation can only occur when fiscal or monetary policy sustains high prices, and
inflation, despite slow growth.

Stabilization policies to control stagflation

1. The money supply should be tightened to check inflation.

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 Macroeconomics 4

2. We can control inflationary wage and price increases with direct controls. Government can limit
increases by law or constrain them through tax policies.

3. Protect people against the effects of inflation. All wages, including the minimum wage,
could be increased automatically when the Consumer Price Index increases. Government
bonds could pay a fixed real interest rate by adjusting the actual interest rate for inflation.

However, there are some practical difficulties in applying these policies in real situations. Wage and
price controls cannot work unless there is a broad political consensus that they are necessary.
Without political will it can’t be followed. Again, adjusting wages in response to consumer prices will
make the economy even more inflation-prone. Tighter monetary policies will not help in increasing
output. Without increasing money supply, we can’t increase consumer spending. And, without
increased consumer spending employment can’t be increased.

So, government control and intervention is vital for stabilization. The government can increase
spending by investing in infrastructure projects. It will boost the manufacturing sector. At the same
time, it will provide employment to the unskilled labor. Thus the consumer spending can be increased
also .In addition to this, the government can frame policies to increase the wages as prices rise- e.g.
DA (dearness allowances), wage revision policies etc.

Stagflation is difficult to control without government controls. Therefore, political will is necessary
for formulating the measures to stop stagflation.

CONCLUSION

We cannot stabilize the economy using monetary or fiscal policy in isolation. Rather we will have to
use a judicious mix of both fiscal and monetary policy to stabilize the economy. Similarly, we should
apply supply side as well as demand side approach to solve these macroeconomic problems.
Following a single approach or policy will not help our cause.

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07bs3884 IBS ,Hyderabad Dec 2007