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Economic and Social Environment

Q. There is a strong relationship between unemployment and inflation. India's situation is different.

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

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
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

If the Govt. INCREASES the benefits they pay to the If the Govt. DECREASES the benefits they pay to
unemployed/underemployed in general this the unemployed/underemployed in general this
produces a higher level of FRICTIONAL produces a lower level of FRICTIONAL
unemployment. People tend to stay unemployed unemployment. People tend to stay unemployed
for longer periods of time because the for shorter periods of time because the
replacement income they receive from the govt. is replacement income they receive from the govt. is
closer to their lost income…In other words, the much LESS then their original income…In other
incentive to look for a Job is diminished and the words, the incentive to look for a job is INCREASES
tendency to stay unemployed increases.. and the tendency to stay unemployed

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 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
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-digitdigit 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.