Unemployment And Inflation
The Expectations-Augmented Phillips Curve


1. 2. 3. 4.


Macro Economics Report

Page 2

Unemployment And Inflation


Firstly, we pay thanks to “ALMIGHTY ALLAH” who helped us to achieve our target. No report is the result of an individual effort only. This report would not have been possible without the help of first and foremost our course instructor Syed Zia Abbas Rizvi, thank you for acquainting us with the world of Macro Economics. As one a scholar said, “My parents brought me from the skies to the earth, but my teacher put me back on the skies” and so did Mr Zia Abbas Rizvi.

Macro Economics Report

Page 3

Unemployment And Inflation

Executive Summary

Pakistan has undergone a significant economic growth during last few years, but the core problems of the economy are still unsolved. Inflation and unemployment remain still the major hurdles to the growth of Pakistan’s economy. Our aim is to find the determinants of inflation and unemployment, causes and corrective measures of it. The last five years are reported as highly inflationary due to expansionary monetary policy and high oil prices. Domestic production should be encouraged instead of imports; investment should be done in capital goods instead of luxuries. Agriculture sector should be given subsidies, foreign investment should be attracted. Developed nations should be requested for financial assistance. And lastly a strong monitoring system should be established on different levels in order to have a sound evaluation of the process at every stage.

Macro Economics Report

Page 4

Unemployment And Inflation

Our study will be focused on various aspects of inflation and unemployment in Pakistan over a period of time.

1. Present the scenario of inflation and unemployment in Pakistan. 2. Highlight the measures used by the SBP (State Bank of Pakistan) to

control inflation and unemployment.

Unemployment, as defined by the International Labor Organization, occurs when people are without jobs and they have actively looked for work within the past four weeks. The unemployment rate is a measure of the prevalence of unemployment and it is calculated as a percentage by dividing the number of unemployed individuals by all individuals currently in the labor force. There remains considerable theoretical debate regarding the causes, consequences and solutions for unemployment. Classical, neoclassical and the Austrian School of economics focus on market mechanisms and rely on the invisible hand of the market to resolve unemployment.

In traditional societies, salary jobs did not exist yet, because money was not invented yet. These cultures lived off the land directly, and the land belonged to the tribe or to no one. Everyone knew how to build shelter and make food. When these cultures invented currency and moved to the cities, they began to depend on money to buy food from a middle man, instead of growing, gathering, or hunting the food directly from nature. Dependence on jobs to make money to buy food and shelter was the beginning of unemployment.
Macro Economics Report Page 5

Unemployment And Inflation Recognition of unemployment occurred slowly as economies across the world industrialized and bureaucratized. The recognition of the concept of "unemployment" is best exemplified through the well documented historical records in England.

Economists distinguish between various overlapping types of and theories of unemployment, including cyclical or Keynesian unemployment, frictional unemployment, structural unemployment and classical unemployment. Some additional types of unemployment that are occasionally mentioned are seasonal unemployment, hardcore unemployment, and hidden unemployment. Though there have been several definitions of voluntary and involuntary unemployment in the economics literature, a simple distinction is often applied. Voluntary unemployment is attributed to the individual's decisions, whereas involuntary unemployment exists because of the socio-economic environment (including the market structure, government intervention, and the level of aggregate demand) in which individuals operate. In these terms, much or most of frictional unemployment is voluntary, since it reflects individual search behavior. Voluntary unemployment includes workers who reject low wage jobs whereas involuntary unemployment includes workers fired due to an economic crisis, industrial decline, company bankruptcy, or organizational restructuring. On the other hand, cyclical unemployment, structural unemployment, and classical unemployment are largely involuntary in nature. However, the existence of structural unemployment may reflect choices made by the unemployed in the past, while classical (natural) unemployment may result from the legislative and economic choices made by labour unions or political parties. So, in practice, the distinction between voluntary and involuntary unemployment is hard to draw. The clearest cases of involuntary unemployment are those where there are fewer job vacancies than unemployed workers even when wages are allowed to adjust, so that even if all vacancies were to be filled, some unemployed workers would still remain. This happens with cyclical unemployment, as macroeconomic forces cause microeconomic unemployment which can boomerang back and exacerbate these macroeconomic forces.

Macro Economics Report

Page 6

Unemployment And Inflation

Classical or real-wage unemployment occurs when real wages for a job are set above the market-clearing level, causing the number of job-seekers to exceed the number of vacancies. Most economists have argued that unemployment increases the more the government intervenes into the economy to try to improve the conditions of those with jobs. For example, minimum wage laws raise the cost of laborers with few skills to above the market equilibrium, resulting in people who wish to work at the going rate but cannot as wage enforced is greater than their value as workers becoming unemployed. Laws restricting layoffs made businesses less likely to hire in the first place, as hiring becomes more risky, leaving many young people unemployed and unable to find work. However, this argument is criticized for ignoring numerous external factors and overly simplifying the relationship between wage rates and unemployment- in other words, that other factors may also affect unemployment. It is noted that there can be unemployment when job market is in equilibrium.

Cyclical or Keynesian unemployment, also known as deficient-demand unemployment, occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work. Demand for most goods and services falls, less production is needed and consequently fewer workers are needed, wages are sticky and do not fall to meet the equilibrium level, and mass unemployment results. Its name is derived from the frequent shifts in the business cycle although unemployment can also be persistent as occurred during the Great Depression of the 1930s. With cyclical
Macro Economics Report Page 7

Unemployment And Inflation unemployment, the number of unemployed workers exceeds the number of job vacancies, so that even if full employment was attained and all open jobs were filled, some workers would still remain unemployed. Some associate cyclical unemployment with frictional unemployment because the factors that cause the friction are partially due to cyclical variables. Classical economists reject the conception of cyclical unemployment and alternatively suggest that the invisible hand of free markets will respond quickly to unemployment and underutilization of resources by a fall in wages followed by a rise in employment. Similarly, Hayek and others from the Austrian school of economics argue that if governments intervene through monetary policy to lower interest rates this will exacerbate unemployment by preventing the market from responding effectively. Keynesian economists on the other hand see the lack of demand for jobs as potentially resolvable by government intervention. One suggested interventions involves deficit spending to boost employment and demand. Another intervention involves an expansionary monetary policy that increases the demand of money which should reduce interest rates which should lead to an increase in non-governmental spending.

It is in the very nature of the capitalist mode of production to overwork some workers while keeping the rest as a reserve army of unemployed paupers.
Macro Economics Report Page 8

Unemployment And Inflation – Marx, Theory of Surplus Value. According to Karl Marx, unemployment is inherent within the unstable capitalist system and periodic crises of mass unemployment are to be expected. The function of the proletariat within the capitalist system is to provide a "reserve army of labour" that creates downward pressure on wages. This is accomplished by dividing the proletariat into surplus labour (employees) and under-employment (unemployed). This reserve army of labour fight among themselves for scarce jobs at lower and lower wages. At first glance, unemployment seems inefficient since unemployed workers do not increase profits. However, unemployment is profitable within the global capitalist system because unemployment lowers wages which are costs from the perspective of the owners. From this perspective low wages benefit the system by reducing economic rents. Yet, it does not benefit workers. Capitalism unfairly manipulates the market for labour by perpetuating unemployment which lowers laborers' demands for fair wages. Workers are pitted against one another at the service of increasing profits for owners. According to Marx, the only way to permanently eliminate unemployment would be to abolish capitalism and the system of forced competition for wages and then shift to a socialist or communist economic system. For contemporary Marxists, the existence of persistent unemployment is proof of the inability of capitalism to ensure full employment.

In The General Theory, Keynes argued that neo-classical economic theory did not apply during recessions because of excessive savings and weak private investment in an economy. In consequence, people could be thrown out of work involuntarily and not be able to find acceptable new employment. This conflict between the neoclassical and Keynesian theories has had strong influence on government policy. The tendency for government is to curtail and eliminate unemployment through increases in benefits and government jobs, and to encourage the job-seeker to both consider new careers and relocation to another city. Involuntary unemployment does not exist in agrarian societies nor is it formally recognized to exist in underdeveloped but urban societies, such as the mega-cities of Africa and of India/Pakistan. In such societies, a suddenly unemployed person must meet their survival needs either by getting a new job at any price, becoming an entrepreneur, or joining the underground economy of the hustler.
Macro Economics Report Page 9

Unemployment And Inflation

Short-Run Phillips Curve before and after Expansionary Policy, with Long-Run Phillips Curve (NAIRU) In demand-based theory, it is possible to abolish cyclical unemployment by increasing the aggregate demand for products and workers. However, eventually the economy hits an "inflation barrier" imposed by the four other kinds of unemployment to the extent that they exist. Some demand theory economists see the inflation barrier as corresponding to the natural rate of unemployment. The "natural" rate of unemployment is defined as the rate of unemployment that exists when the labour market is in equilibrium and there is pressure for neither rising inflation rates nor falling inflation rates. An alternative technical term for this rate is the NAIRU or the Non-Accelerating Inflation Rate of Unemployment. No matter what its name, demand theory holds that this means that if the unemployment rate gets "too low," inflation will get worse and worse (accelerate) in the absence of wage and price controls (incomes policies). One of the major problems with the NAIRU theory is that no one knows exactly what the NAIRU is (while it clearly changes over time). The margin of error can be quite high relative to the actual unemployment rate, making it hard to use the NAIRU in policy-making. Another, normative, definition of full employment might be called the ideal unemployment rate. It would exclude all types of unemployment that represent forms of inefficiency. This type of "full employment" unemployment would correspond to only frictional unemployment (excluding that part encouraging the McJobs management strategy) and would thus be very low. However, it would be impossible to attain this full-employment target using only demand-side Keynesian stimulus without getting below the NAIRU and suffering from accelerating inflation (absent incomes policies). Training programs aimed at fighting structural unemployment would help here. To the extent that hidden unemployment exists, it implies that official unemployment statistics provide a poor guide to what unemployment rate coincides with "full employment".

Macro Economics Report

Page 10

Unemployment And Inflation


"Driver looking for work" Unemployed German laborer in 1949 Structural unemployment occurs when a labour market is unable to provide jobs for everyone who wants one because there is a mismatch between the skills of the unemployed workers and the skills needed for the available jobs. Structural unemployment is hard to separate empirically from frictional unemployment, except to say that it lasts longer. As with frictional unemployment, simple demand-side stimulus will not work to easily abolish this type of unemployment. Structural unemployment may also be encouraged to rise by persistent cyclical unemployment: if an economy suffers from long-lasting low aggregate demand, it means that many of the unemployed become disheartened, while their skills (including job-searching skills) become "rusty" and obsolete. Problems with debt may lead to homelessness and a fall into the vicious circle of poverty. This means that they may not fit the job vacancies that are created when the economy recovers. Some economists see this scenario as occurring under British Prime Minister Margaret Thatcher during the 1970s and 1980s. The implication is that sustained high demand may lower structural unemployment. This theory of
Macro Economics Report Page 11

Unemployment And Inflation persistence in structural unemployment has been referred to as an example of path dependence or "hysteresis". Much technological unemployment (e.g. due to the replacement of workers by machines) might be counted as structural unemployment. Alternatively, technological unemployment might refer to the way in which steady increases in labour productivity mean that fewer workers are needed to produce the same level of output every year. The fact that aggregate demand can be raised to deal with this problem suggests that this problem is instead one of cyclical unemployment. As indicated by Okun's Law, the demand side must grow sufficiently quickly to absorb not only the growing labour force but also the workers made redundant by increased labour productivity. Otherwise, we see a jobless recovery such as those seen in the United States in both the early 1990s and the early 21st century. Seasonal unemployment may be seen as a kind of structural unemployment, since it is a type of unemployment that is linked to certain kinds of jobs (construction work, migratory farm work). The most-cited official unemployment measures erase this kind of unemployment from the statistics using "seasonal adjustment" techniques.


Beveridge curve of 2004 job vacancyand unemployment rate from the United States Bureau of Labour Statistics Frictional unemployment is the time period between jobs when a worker is searching for, or transitioning from one job to another. It is sometimes called search unemployment and can be voluntary based on the circumstances of the unemployed individual. Frictional unemployment is always present in an economy, so the level of involuntary unemployment is
Macro Economics Report Page 12

Unemployment And Inflation properly the unemployment rate minus the rate of frictional unemployment, which means that increases or decreases in unemployment are normally under-represented in the simple statistics.[55] Frictional unemployment exists because both jobs and workers are heterogeneous, and a mismatch can result between the characteristics of supply and demand. Such a mismatch can be related to skills, payment, work-time, location, seasonal industries, attitude, taste, and a multitude of other factors. New entrants (such as graduating students) and re-entrants (such as former homemakers) can also suffer a spell of frictional unemployment. Workers as well as employers accept a certain level of imperfection, risk or compromise, but usually not right away; they will invest some time and effort to find a better match. This is in fact beneficial to the economy since it results in a better allocation of resources. However, if the search takes too long and mismatches are too frequent, the economy suffers, since some work will not get done. Therefore, governments will seek ways to reduce unnecessary frictional unemployment through multiple means including providing education, advice, training, and assistance such as daycare centers. The frictions in the labour market are sometimes illustrated graphically with a Beveridge curve, a downward-sloping, convex curve that shows a correlation between the unemployment rate on one axis and the vacancy rate on the other. Changes in the supply of or demand for labour caused movements along this curve. An increase (decrease) in labour market frictions will shift the curve outwards (inwards).

Macro Economics Report

Page 13

Unemployment And Inflation

Hidden, or covered, unemployment is the unemployment of potential workers that is not reflected in official unemployment statistics, due to the way the statistics are collected. In many countries only those who have no work but are actively looking for work (and/or qualifying for social security benefits) are counted as unemployed. Those who have given up looking for work (and sometimes those who are on Government "retraining" programs) are not officially counted among the unemployed, even though they are not employed. The same applies to those who have taken early retirement to avoid being laid off, but would prefer to be working. The statistic also does not count the "underemployed" - those with part time or seasonal jobs who would rather have full time jobs. In addition, those who are of working age but are currently in full-time education are usually not considered unemployed in government statistics. Because of hidden unemployment, official statistics often underestimate unemployment rates.

Though many people care about the number of unemployed individuals, economists typically focus on the unemployment rate. This corrects for the normal increase in the number of people employed due to increases in population and increases in the labour force relative to the population. The unemployment rate is expressed as a percentage, and is calculated as follows: UNEMPLOYMENT RATE = UNEMPLOYED WORKERS TOTAL LABOUR FORCE As defined by the International Labour Organization, "unemployed workers" are those who are currently not working but are willing and able to work for pay, currently available to work, and have actively searched for work. [58] Individuals who are actively seeking job placement must make the effort to: be in contact with an employer, have job interviews, contact job placement agencies, send out resumes, submit applications, respond to advertisements, or some other means of active job searching within the prior four weeks. Simply looking at advertisements and not responding will not count as actively seeking job placement. Since not all unemployment may be "open" and counted by government agencies, official statistics on unemployment may not be accurate.
Macro Economics Report Page 14

Unemployment And Inflation

The equilibrium unemployment level is the difference between those who are employed at a given wage rate and those who can work. In other words, there is equilibrium with respect to the demand and supply of labour, however, unemployment still exists because a proportion of the labour force are not willing to work at that time and that wage rate.

It happens when the aggregate demand for labour is less than the aggregate supply of labour at the current real wage rate.

Rank Country Unemployment rate (%) (top 78 countires)

14 1 2 3 4 5 Nauru 90 Liberia Zimbabwe 85 80 15 16 17

Afghanistan 40

Herzegovina 29 26 Mayotte 25.4 Dominica South Africa 22.9 23


40 27 28

Burkina Faso77 Turkmenistan 60

Marshall Islands 36 Yemen 35

6 Cocos (Keeling) Islands 60 7 8 9 10 11 12 13 Djibouti Zambia Senegal Nepal 46 Lesotho Gaza Strip 41.3 Kenya 40 45 59 50 48

18 Macedonia, The Former Yugoslav Republic of 33.5 19 20 21 Mali 30 30

29 Micronesia, Federated States of 22 30 31 32 33 34 Gabon21 Cape Verde 21 Mozambique 21 Comoros East Timor Saint Lucia Sudan 18.7 Iraq 18.2 Page 15 20 20 20

Mauritania Libya 30

22 Equatorial Guinea 30 23 24 25 Cameroon 30

35 36 37

American Samoa 29.8 Bosnia and

Macro Economics Report

Unemployment And Inflation
38 39 40 Kyrgyzstan 18 New Caledonia 17.1 West Bank 16.3 51 52 53 54 55 56 57 58 59 60 61 62 63 64 Spain 13.9 Croatia 13.7 Georgia 13.6 Cook Islands 13.1 Tonga 13 Jordan12.6 Iran 12.5 72 65 66 67 Guam 11.4 Colombia 11.3 Ghana11

41 Netherlands Antilles 15.5 42 Dominican Republic 15.5 43 Wallis and Futuna 15.2 44 Saint Vincent and the Grenadines 15 45 46 47 48 49 50 Bahrain Oman 15 Montenegro 14.7 Maldives 14.4 Tunisia 14.1 Saint Helena 14 15

68 Antigua and Barbuda 11 69 70 71 Jamaica Guyana Barbados 10.7 Turkey 10.7 11 11

Grenada 12.5 Albania 12.5 Algeria 12.5 Niue 12 Puerto Rico 12 Saudi Arabia 11.8 French Polynesia 11.7

73 Saint Pierre and Miquelon 10.3 74 Turks and Caicos Islands 10 75 76 77 78 Morocco Poland Suriname Burma 10 9.8 9.5 9.5

Macro Economics Report

Page 16

This entry contains the percent of the labor force that is without jobs. Substantial underemployment might be noted. Source: CIA World Factbook

INDIVIDUAL:Unemployed individuals are unable to earn money to meet financial obligations. Failure to pay mortgage payments or to pay rent may lead to homelessness through foreclosure or eviction. Across the United States the growing ranks of people made homeless in the foreclosure crisis are generating tent cities. Unemployment increases susceptibility to malnutrition, illness, mental stress, and loss of self-esteem, leading to depression. According to a study published in Social Indicator Research, even those who tend to be optimistic find it difficult to look on the bright side of things when unemployed. Using interviews and data from German participants aged 16 to 94 – including individuals coping with the stresses of real life and not just a volunteering student population – the researchers determined that even optimists struggled with being unemployed. Dr. M. Brenner conducted a study in 1979 on the "Influence of the Social Environment on Psychology." Brenner found that for every 10% increase in the number of unemployed there is an increase of 1.2% in total mortality, a 1.7% increase in cardiovascular disease, 1.3% more cirrhosis cases, 1.7% more suicides, 4.0% more arrests, and 0.8% more assaults reported to the police.[86] A more recent study by Christopher Ruhm[87] on the effect of recessions on health found that several measures of health actually improve during recessions. As for the impact of an economic downturn on crime, during the Great Depression the crime rate did not decrease. Because unemployment insurance in the U.S. typically does not replace 50% of the income one received on the job (and one cannot receive it forever), the unemployed often end up tapping welfare programs such as Food Stamps or accumulating debt. Not everyone suffers equally from unemployment. In a prospective study of 9570 individuals over four years, highly conscientiousness people suffered more than twice as much if they became unemployed.[88] The authors suggested this may be due to conscientious people making different attributions about why they became unemployed, or through

experiencing stronger reactions following failure. Some hold that many of the low-income jobs are not really a better option than unemployment with a welfare state (with its unemployment insurance benefits). But since it is difficult or impossible to get unemployment insurance benefits without having worked in the past, these jobs and unemployment are more complementary than they are substitutes. (These jobs are often held short-term, either by students or by those trying to gain experience; turnover in most low-paying jobs is high.) Another cost for the unemployed is that the combination of unemployment, lack of financial resources, and social responsibilities may push unemployed workers to take jobs that do not fit their skills or allow them to use their talents. Unemployment can cause underemployment, and fear of job loss can spur psychological anxiety.

SOCIAL:An economy with high unemployment is not using all of the resources, specifically labour, available to it. Since it is operating below its production possibility frontier, it could have higher output if all the workforce were usefully employed. However, there is a trade-off between economic efficiency and unemployment: if the frictionally unemployed accepted the first job they were offered, they would be likely to be operating at below their skill level, reducing the economy's efficiency.[89] During a long period of unemployment, workers can lose their skills, causing a loss of human capital. Being unemployed can also reduce the life expectancy of workers by about 7 years [90] High unemployment can encourage xenophobia and protectionism as workers fear that foreigners are stealing their jobs.[91] Efforts to preserve existing jobs of domestic and native workers include legal barriers against "outsiders" who want jobs, obstacles to immigration, and/or tariffs and similar trade barriers against foreign competitors. High unemployment can also cause social problems such as crime; if people don't have as much disposable income as before, then it is very likely that crime levels within the economy will increase.

Macro Economics Report

Page 18

SOCIO-POLITICAL:High levels of unemployment can be causes of civil unrest, in some cases leading to revolution, and particularly totalitarianism. The fall of the Weimar Republic in 1933 and Adolf Hitler's rise to power, which culminated in World War II and the deaths of tens of millions and the destruction of much of the physical capital of Europe, is attributed to the poor economic conditions in Germany at the time, notably a high unemployment rate[92] of above 20%; see Great Depression in Central Europe for details. Note that the hyperinflation in the Weimar republic is not directly blamed for the Nazi rise – the Inflation in the Weimar Republic occurred primarily in the period 1921–23, which was contemporary with Hitler's Beer Hall Putsch of 1923, and is blamed for damaging the credibility of democratic institutions, but the Nazi party only assumed government in 1933, 10 years after the hyperinflation but in the midst of high unemployment.

Unemployment is argued to be "beneficial" to the people who are not unemployed in the sense that it averts inflation, which itself has damaging effects, by providing (in Marxian terms) a reserve army of labour, that keeps wages in check. However the direct connection between full local employment and local inflation has been disputed by some due to the recent increase in international trade that supplies low-priced goods even while local employment rates rise to full employment.[93] In the Shapiro-Stiglitz model of efficiency wages, workers are paid at a level that dissuades shirking. This prevents wages from dropping to market clearing levels. Full employment cannot be achieved because workers would shirk if they were not threatened with the possibility of unemployment. Because of this, the curve for the no-shirking condition (labeled NSC) goes to infinity at full employment. The inflation-fighting benefits to the entire economy arising from a presumed optimum level of unemployment has been studied extensively.[94] The Shapiro-Stiglitz model suggests that wages are not bid down sufficiently to ever reach 0% unemployment.[95] This occurs because employers know that when wages decrease, workers will shirk and expend less effort. Employers avoid shirking by preventing wages from decreasing so low that workers give
Macro Economics Report Page 19

up and become unproductive. These higher wages perpetuate unemployment while the threat of unemployment reduces shirking. Before current levels of world trade were developed, unemployment was demonstrated to reduce inflation, following the Phillips curve, or to decelerate inflation, following the NAIRU/natural rate of unemployment theory, since it is relatively easy to seek a new job without losing one's current one. And when more jobs are available for fewer workers (lower unemployment), it may allow workers to find the jobs that better fit their tastes, talents, and needs. As in the Marxist theory of unemployment, special interests may also benefit: some employers may expect that employees with no fear of losing their jobs will not work as hard, or will demand increased wages and benefit. According to this theory, unemployment may promote general labour productivity and profitability by increasing employers' rationale for their monopsony-like power (and profits).[50] Optimal unemployment has also been defended as an environmental tool to brake the constantly accelerated growth of the GDP to maintain levels sustainable in the context of resource constraints and environmental impacts.[96] However the tool of denying jobs to willing workers seems a blunt instrument for conserving resources and the environment—it reduces the consumption of the unemployed across the board, and only in the short term. Full employment of the unemployed workforce, all focused toward the goal of developing more environmentally efficient methods for production and consumption might provide a more significant and lasting cumulative environmental benefit and reduced resource consumption.[97] If so the future economy and workforce would benefit from the resultant structural increases in the sustainable level of GDP growth. Some critics of the "culture of work" such as anarchist Bob Black see employment as overemphasized culturally in modern countries. Such critics often propose quitting jobs when possible, working less, reassessing the cost of living to this end, creation of jobs which are "fun" as opposed to "work," and creating cultural norms where work is seen as unhealthy. These people advocate an "anti-work" ethic for life.

Societies try a number of different measures to get as many people as
Macro Economics Report Page 20

possible into work, and various societies have experienced close to full employment for extended periods, particularly during the Post-World War II economic expansion. The United Kingdom in the 1950s and 60s averaged 1.6% unemployment,[99] while in Australia the 1945 White Paper on Full Employment in Australia established a government policy of full employment, which policy lasted until the 1970s when the government ran out of money. However, mainstream economic discussions of full employment since the 1970s suggest that attempts to reduce the level of unemployment below the natural rate of unemployment will fail, resulting only in less output and more inflation.

Many countries aid the unemployed through social welfare programs. These unemployment benefits include unemployment insurance, unemployment compensation, welfare and subsidies to aid in retraining. The main goal of these programs is to alleviate short-term hardships and, more importantly, to allow workers more time to search for a job. A direct demand-side solution to unemployment is government-funded employment of the able-bodied poor. This was notably implemented in Britain from the 17th century until 1948 in the institution of the workhouse, which provided jobs for the unemployed with harsh conditions and poor wages to dissuade their use. A modern alternative is a job guarantee, where the government guarantees work at a living wage. Temporary measures can include public works programs such as the Works Progress Administration. Government-funded employment is not widely advocated as a solution to unemployment, except in times of crisis; this is attributed to the public sector jobs' existence depending directly on the tax receipts from private sector employment. In the U.S. the unemployment insurance allowance one receives is based solely on previous income (not time worked, family size, etc.) and usually compensates for one-third of one's previous income. To qualify, one must reside in their respective state for at least a year and, of course, work. The system was established by the Social Security Act of 1935. Although 90% of citizens are covered by unemployment insurance, less than 40% apply for and receive benefits. However, the number applying for and receiving benefits increases during recessions. In cases of highly seasonal industries
Macro Economics Report Page 21

the system provides income to workers during the off seasons, thus encouraging them to stay attached to the industry. According to classical economic theory, markets reach equilibrium where supply equals demand; everyone who wants to sell at the market price can. Those who do not want to sell at this price do not; in the labour market this is classical unemployment. Increases in the demand for labour will move the economy along the demand curve, increasing wages and employment. The demand for labour in an economy is derived from the demand for goods and services. As such, if the demand for goods and services in the economy increases, the demand for labour will increase, increasing employment and wages. Monetary policy and fiscal policy can both be used to increase shortterm growth in the economy, increasing the demand for labour and decreasing unemployment.

However, the labour market is not 100% efficient: it does not clear, though it may be more efficient than bureaucracy. Some argue that minimum wages and union activity keep wages from falling, which means too many people want to sell their labour at the going price but cannot. This assumes perfect competition exists in the labour market, specifically that no single entity is large enough to affect wage levels. Advocates of supply-side policies believe those policies can solve this by making the labour market more flexible. These include removing the minimum wage and reducing the power of unions. Supply-siders argue the reforms increase long-term growth. This increased supply of goods and services requires more workers, increasing employment. It is argued that supply-side policies, which include cutting taxes on businesses and reducing regulation, create jobs and reduce unemployment. Other supply-side policies include education to make workers more attractive to employers. However, recent meta-analyzes involving many studies refute that there is any statistically significant, negative impact of minimum wages on unemployment.[102] Further, a number of scholars argue that the predicted negative impact is based on incoherent or simplistic logic that ignores mitigating environmental factors, such as non-minimum wage labour markets including farm, service and self employed workers.[41][42][43][44] [45] They argue that the benefits of minimum wage laws outweigh the supposed but unproven costs.
Macro Economics Report Page 22

Unemployment rate: 15% (2010 est.) 14% (2009 est.) note: substantial underemployment exists Year Unemployment rate Rank Percent ChangeDate of Information 2003 est. 2004 2003 est. 2005 2004 est. 2006 2005 est. 2007 2006 est. 2008 2007 est. 2009 est. 7.80 % 7.70 % 8.30 % 6.60 % 6.50 % 5.60 % 7.40 % 119 122 75 65 72 71 92 143 -1.28 % 7.79 % -20.48 % -1.52 % -13.85 % 32.14 % 89.19 % 2008 2002

2010 14.00 % 2009 est.

This entry contains the percent of the labor force that is without jobs. Substantial underemployment might be noted.

Macro Economics Report

Page 23

The higher growth rate of population is one of the major cause of unemployment in Pakistan. The resources of the country are limited because population has exceeded the optimum level. It can be clearly seen the Pakistan is suffering from over population and the being an underdeveloped country it is very difficult to control this. It also affects the employment rate of Pakistan. The population has been increasing. Although the growth rate is decreasing by the actual figure of population has increased from 85.10 million in 1981 to 149.03 in 2003. This shows the rapid rate of increase in population. In order to minimize the unemployment problem, a strict population policy maybe introduced. Our educational system is also responsible for increasing unemployment rate among the youth. The attitude of our youth towards the choice of a career is unrealistic and unproductive. Rapid mechanization and computer technology also causing unemployment. Less than three-quarters of its school-age population attends primary school. Nearly two-third of the total adult population can’t read or write. Expenditure on education as a percentage of GDP has been less than 2 % in the last decade. The level of unemployment in Pakistan is moving up day by day. The socio economics system of Pakistan and institutions has failed to provide employment to the increasing labor force. The rate of expansion in industrial sector is very slow. In fact, the employment in the private sector has absolutely stopped because they shifted their capital to other countries because of the global economics condition and also as we are the front line state against war on terror. And investors are reluctant to invest here because of the political instability in the country, unrest and violence. The unemployment rate in Pakistan in the year 2007 and 2008 was estimated as 6.5% and 7.5% in the year 2007. In exact terms, it was 5.6% plus substantial underemployment in 2007 and 7.5% estimated in the year 2008. These facts are according to CIA world fact book which comprise of the percentage of labor force which is currently unemployed. According to the Human Development Report on South Asia, Pakistan’s labour force is growing at the rate of 2.4%, and the unemployment rate is growing at an alarming rate of 6% per anum in the last five years.
Macro Economics Report Page 24

As we know that the Pakistan’s economy used to derive great benefit from overseas Pakistanis and expatriate labour abroad, especially the Gulf countries. This was traditionally unskilled labour engaged in the construction boom of the post-1973 oil price hike shock. However, the opportunities for unskilled labour in Arab countries have been reducing due to the economic changes taking place there. With the decline in jobs abroad, the economy’s capacity to generate employment opportunities has been decreasing, which can be figured out from the low growth rates. With the high rate of population growth, rate is further expected to increase in near future because of the current financial crisis in the country.

Macro Economics Report

Page 25

Unemployment is one of the biggest problems of Pakistan. That person is unemployed who has ability to do work and is willing to do work but is unable to get job opportunity. In the current situation more than 30 lakh people are unemployed in Pakistan and unemployment ratio is more than 12%. i. The biggest reason of unemployment in Pakistan is concerned with the backwardness of agriculture sector. Agriculture is the biggest sector of our economy that contributes 20.9% to GDP and 44% people get jobs from this sector directly or indirectly. Unemployment in this sector is from two sides. First is due to the adoption of latest machinery and capital intensive technology. Due to this, demand for labour has been decreased. Second is the backwardness of this sector. There is less availability of fertilisers, pesticides, quality seeds, absence of land reforms and lack of agriculture education. Due to all these factors agriculture sector is not expanding and there is general and disguised unemployment. ii. Industrial sector is the second largest sector of our economy and contributes 19% to national income. This sector should employ a large number of labor. But due to backwardness it is employing a small number of people. Due to electricity breakdown already established industry is deteriorating, resulting in the prevailing unemployment ratio. iii. High cost and low quality are responsible for less demand for our agri and industrial items. Because of less demand of such kinds of goods both the domestic and international producers are losing their interest in production. That’s why people are becoming unemployed. iv. In Pakistan education system is defective. There is no educational planning. This system is producing the stuff, which is useless in technical fields of the country. There is lack of technical and vocational institutions. Public attitude towards education is wrong, they want to get their degrees in general and arts subjects. Nobody can set up his own business without technical education. v. Millions of people in Pakistan are poor. Due to poverty people are overburdened with expenditures and their savings are very low. It is said that for the reasonable growth of economy saving rate should be at least 25% in any country, but in Pakistan it is only 13 to 14% which is very low. Low investment level is due to less savings, ultimately there is
Macro Economics Report Page 26

unemployment. vi. In Pakistan majority of the businessmen are less educated. They do not know how to run their businesses properly. So they become bankrupt. This factor generates unemployment on a massive level. vii. In Pakistan there is lack of every kind of planning. There is a huge difference between the demand and supply for labor. There is absence of such kind of planning to produce doctors, engineers, technical experts scientists etc, according to the need of different sectors of the economy. viii. Loadshedding of electricity is disturbing economy, especially the industrial sector. Due to less availability and high rates of basic inputs like electricity, gas and oil etc, many industries have been closed. ix. In Pakistan, tax system is not satisfactory. Ratio of direct taxes is more than indirect taxes. Tax evasion is common. Due to less income from the taxes, government cannot start developmental projects. If there is no investment, then from where public would find jobs. On the other side if government takes step to increase indirect taxes, it would also affect investment and ultimately employment level. x. Current international financial crisis is one of the biggest reason of unemployment in Pakistan and in the whole world. This crisis originated from the banking sector of USA, UK and some European countries and is now a global phenomena. xi. Pakistan’s population growth rate is 1.8% which is the highest in the region. Our resources are limited. Different sectors of economy are unable to provide jobs to the growing population. So there is unemployment. xii. Fiscal and monetary policies are also responsible for unemployment. In view of fiscal policy, Pakistan has less funds to invest in job providing projects. Every annual budget shows deficit. Through the monetary policy if the government increases the rate of interest, it discourages the investors from getting loans. xiii. Political instability, bad law and order situation, army’s interference, bomb blasts, terrorism, inconsistent economic policies etc are the factors which are disturbing domestic and foreign investment. Pakistan investors are taking away their money to Dubai and other countries of the world. xiv. Due to 9/11 incident, Gulf war and the baseless allegations of terrorism
Macro Economics Report Page 27

the image of Pakistan has been affected very badly at international level. So in the current scenario Pakistan has limited job opportunities in other countries of the world. xv. Craze for work only in government sector, instead of private sector and seasonal firms, industries are also responsible for unemployment. xvi. Since 1947, Pakistani rulers got loans from IMF, World Bank and many other sources. Such loans were not utilised honestly. Current external debt of Pakistan is more than 50 billion dollar. Government has to allocate a big amount for the repayment of loans with interest. So due to less resources for developmental projects there is unemployment. Concluding, I would like to suggest that with proper economic planning, consistent policies of government, better law and order situation, abolishing energy crisis, sincerity with Pakistan and by adopting the Islamic economic system we can not only tackle the issue of unemployment but every economic problem of our country as well.

1) Govt. should make efforts to push economic growth process. For this purpose Economic Revival Package should announce for the revival of industries sector, to stimulate production and investment. 2) Govt. should seriously try to boost exports through broadening the tax base and lowering tariffs. 3) Govt. should announce a package for the development of agriculture sector . 4) Beside this a number of fiscal and monetary measures should take to attract industrialists and particularly foreign investment. 5) More Technical and Vocational training facilities should be provided. In this way unemployed people will get the chance to enhance their skills and become able to earn reasonable income. 6) With a view to reduce educate unemployment; self-employment scheme should be encouraged in true manners.

Macro Economics Report

Page 28

The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.

Demand-pull Inflation:
Demand-pull inflation is also called as wage or excess demand inflation. This type of inflation occurs when total demand for goods and services in an economy exceeds the available supply. this, leading to a situation called as demand-pull inflation. War produces this type of inflation as demand for war materials and manpower grows rapidly during that time.

Cost-push Inflation:
As the name suggests, when the cost of production of goods and services increases, there is likely to be an increase in the prices of finished goods and services. For instance, a rise in the wages of laborers is what raises the unit costs of production and thus raises price. This is less common than demandpull inflation. This type of inflation may or may not occur in conjunction with demand-pull inflation.

Pricing Power Inflation:
Macro Economics Report Page 29

Pricing power inflation is more often called as administered price inflation. This type of inflation occurs when the businesses decide to increase their prices to increase their profit margins. Pricing power inflation does not occur at the time of financial crises and economic depression, or when there is a downturn in the economy. This type of inflation is also called as oligopolistic inflation because oligopolies have the power of to set their own prices.

Sectoral Inflation:
This is the fourth major type of inflation. The sectoral inflation takes place when there is an increase in the prices of the goods and services produced by a certain sector of industries. For instance, an increase in the cost of crude oil would directly affect all the sectors, which are directly related to the oil industry. Thus, the ever-increasing price of fuel has become an important issue related to the economy all over the world. This would lead to a widespread inflation throughout the economy. If this situation occurs when there is a recession in the economy, there would be layoffs and it would adversely affect the work force and the economy in turn

Hyperinflation is also known as runaway inflation or galloping inflation. This type of inflation occurs during or soon after a war. This can usually lead to the complete breakdown of a country’s monetary system. However, this type of inflation is short-lived. In 1923, in Germany, inflation rate touched approximately 322 percent per month with October being the month of highest inflation.

Macro Economics Report

Page 30

It is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. Taking price changes for each item in the predetermined basket of goods and averaging them calculate the CPI; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.
Calculating the CPI for a single item

Where 1 is usually the comparison year and CPI1 is usually an index of 100. Alternately, the CPI can be performed as:

The "updated cost" (i.e the price of an item at a given year, eg: the price of bread in 1982) is divided by the initial year (the price of bread in 1970), then multiplied by one hundred.

A Producer Price Index (PPI) measures price change from the perspective of the seller. It measures average changes in prices received by domestic producers for their output. The PPI shows trends within the wholesale markets (the PPI was once called the Wholesale Price Index), manufacturing industries and commodities markets.

GDP deflator (implicit price deflator for GDP) is a measure of the level of prices of all new, domestically produced, final goods and services in an

Macro Economics Report

Page 31

economy. GDP stands for gross domestic product, the total value of all final goods and services produced within that economy during a specified period. the GDP deflator measures the ratio of nominal (or current-price) GDP to the real (or chain volume) measure of GDP. The formula used to calculate the deflator is:

Dividing the nominal GDP by the GDP deflator and multiplying it by 100 would then give the figure for real GDP, hence deflating the nominal GDP into a real measure. Unlike some price indexes, the GDP deflator is not based on a fixed basket of goods and services. The basket is allowed to change with people's consumption and investment patterns. The theory behind this approach is that the GDP deflator reflects up to date expenditure patterns. For instance, if the price of chicken increases relative to the price of beef, it is claimed that people will likely spend more money on beef as a substitute for chicken. Pakistan publishes four different price indices, namely: the consumer price index (CPI), the wholesale price index (WPI), the sensitive price index (SPI) and the GDP deflator. The CPI is the main measure of price changes at the retail level. It indicates the cost of purchasing a representative fixed basket of goods and services consumed by private households. In Pakistan, the CPI covers the retail prices of 374 items in 35 major cities and reflects roughly the changes in the cost of living of urban areas. The WPI is designed for those items which are mostly consumable in daily life on the primary and secondary level; these prices are collected from wholesale markets as well as from mills at organised wholesale market level. It covers the wholesale price of 106 commodities prevailing in 18 major cities of Pakistan. The SPI shows the weekly change of price of 53 selected items of daily use consumed by those households whose monthly income in the base year 2000-01 ranged from Rs3000 to above Rs12000 per month. The SPI also informs about the actual position of supply: whether the commodity is available in market or not. If the commodity is not available, the reason for that is also recorded. It is based on the prices prevailing in 17 major cities and is computed for the basket of commodities being consumed by the households belonging to all income groups combined as in CPI. In most
Macro Economics Report Page 32

countries, the main focus for assessing inflationary trends is placed on the CPI, because it most closely represents the cost of living. In Pakistan, the main focus is also placed on the CPI as a measure of inflation as it is more representative with a wider coverage of 374 items in 71 markets of 35 cities around the country. Inflation has started veering its ugly head in many parts of the world, including Pakistan. Food inflation has emerged as the main contributor to inflationary pressures. The inflation rates based on CPI, SPI and WPI for the year 2008-09 increased by 22.35 per cent, 26.33 per cent and 21.44 per cent respectively over the corresponding period of 2007-08. It increased by 10.27 per cent, 14.09 per cent and 13.70 per cent respectively in 2007-08 over the corresponding period of 2006-07. In 2006-07, the rate of inflation increased by 7.89 per cent, 11.13 per cent and 6.92 per cent respectively over the same period of 2005-06. An analysis of data for last three years for the same period indicates that CPI, SPI & WPI were higher as compared to last two years. The government is cautious about inflation and thus has taken various steps to release demand pressures on the one hand and enhance supplies of essential commodities on the other. To ease demand pressures, the State Bank of Pakistan (SBP) has continuously tightened the monetary policy over the last three years and more so in the current fiscal year, while to enhance supplies, the government has relaxed its import regime and allowed imports of several essential items so that there is a continuous flow in the supply of those important commodities. In addition, the government increased the imports of items like wheat, pulse and sugar to complement the efforts of the private sector. In order to provide relief to the common man, the government also increased the scale of operations of the Utility Stores Corporation (USC) which supplies essential commodities such as wheat flour, sugar, pulses and cooking oil/ ghee at less than the market prices.

Average July–April over same period of previous year (Change of indices in %) Index 2006-07 2007-08 2008-09
Page 33

Macro Economics Report


7.89 11.13 6.92

10.27 14.09 13.70

22.35 26.33 21.44

Consumer Price Index (CPI) rose by 11.73 percent in 2009/10, surpassing the government’s target of 10 percent, mainly because of unprecedented increase in the electricity tariff.It was, however, below the central bank’s projection of 12 percent. In the last financial year, CPI had gone up by 21 percent. “CPI could have been contained to a single digit figure if the electricity charges had not been raised during the year,” said an analyst. The government had to raise electricity prices because of a commitment with the International Monetary Fund (IMF). Food inflation came down to 14.48 percent from over 30 percent in the previous fiscal. In June, inflation stood at 12.69 percent, according to figures released by the Federal Board of Statistics (FBS). Khurram Schehzad, an analyst at InvesCap, said that the drop in CPI was mainly due to higher base affect, but reduction in oil prices also had its impact. He said that inflation would continue to remain in double digit figures during the current fiscal year because of higher dependence on furnace oil for power generation. “The high cost of power generation will result in rise in electricity tariff, which will lead to inflationary pressures.” The non-perishable food items index rose 13.64 percent and the perishable items index 20.76 percent. House rent index climbed 9.69 percent, while fuel and lighting index surged 16.36 percent. Transport and communication expenses were higher by 15.82 percent. Education and health expenses went up by 8.36 percent and 10.59 percent, respectively. Sensitive Price Index (SPI) and Wholesale Price Index (WPI) increased by 13.32 percent and 12.63 percent, respectively.

Macro Economics Report

Page 34

Soaring food and oil prices drove inflation in Pakistan to its highest level in over 30 years in May, and analysts expect it to rise further as the government was expected to slash price subsidies in a budget to be announced later on Wednesday. Official data on Wednesday showed the consumer price index rose 2.69 per cent in May to stand 19.27 per cent higher than a year earlier, after a 17.21 per cent year-on-year rise in April. “There are two factors driving inflation, high food prices and the second is the base effect of passing the burden of oil prices,” said Asif Qureshi, head of research at Invisor Securities Ltd. Prices of food and beverages rose 28.48pc in May, while house rent and fuel and lighting increased by 12.05 per cent and 9.50 per cent, respectively. Inflation is at its highest since 1975 when annual average prices rose 26.83 per cent. Analysts said monthly data started being released in 1991 and therefore it was difficult to make an exact comparison of inflation figures. Total budget subsidies on fuel oil, electricity, fertilisers and food items were due to be reduced to 295.20 billion rupees from 407.48 billion rupees.


The effect of inflation is not distributed evenly in the economy, and as a consequence there are hidden costs to some and benefits to others from this decrease in the purchasing power of money. For example, with inflation, lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings, while their borrowers benefit. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. Increases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments. Increases in the price level (inflation) erode the real value of money (the functional currency) and other items with an underlying monetary nature (e.g. loans and bonds). However, inflation has no effect on
Macro Economics Report Page 35

the real value of non-monetary items, (e.g. goods and commodities, gold, real estate). Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The “real” interest on a loan is the nominal rate minus the inflation rate When the balance between supply and demand spirals out of control, buyers will change their spending habits as they meet their purchasing thresholds and producers will suffer and be forced to cut output. This can be readily tied to higher unemployment rates. When extremes arise in the supply/demand structure, imbalances are created. The point that is being made is that if inflation is not contained and rises at an unsustainable rate; there will be a stronger impact on the other side. There is a saying; "the bigger they are, the harder they fall". The most immediate effects of inflation are the decreased purchasing power of the rupee and its depreciation. Depreciation is especially hard on retired people with fixed incomes, as spending power decreases each month. Those not on fixed incomes are more able to cope, because they can simply increase their income. Another destabilising effect of inflation is that some people choose to speculate heavily in an attempt to take advantage of the higher price level. Because some of the purchases are high-risk investments, spending is diverted from the normal channels and some structural unemployment may take place. Finally, inflation alters the distribution of income. Lenders are generally hurt more than borrowers during long inflationary periods, which mean that loans made earlier are repaid later in inflated rupees. Inflation weakens the function of money as storage of value, because each unit of money is worth less with the passing of time. The progressive loss of the value of money during a period of inflation makes the borrowers to be less willing to use the money as standard differed payments


The demand-pull theory suggests that inflation occurs when aggregate demand exceeds aggregate supply; essentially, the number of people wanting to purchase goods and services outweighs what is available. When more people want to spend money on something, the price will increase to account for the greater demand. This scenario is typically associated with a strong economy and low unemployment, when more people put money into the economy.

Macro Economics Report

Page 36

• Cost-push inflation occurs when goods and services become more expensive to produce, which means prices increase to maintain a desirable profit margin. A shortage of raw materials also can contribute to cost-push inflation. One example of this was the 1973 oil crisis, when some Middle Eastern and North African countries placed an embargo on oil exports to the U.S.

The monetarist theory suggests the money supply determines inflation, which occurs when the rate of a country's income rises faster than economic growth. If additional money is pumped into the economy while prices of goods and services remain the same, it will potentially result in inflation. Top causes of an increased money supply are banks increasing lending, or central banks, such as the Federal Reserve, printing more money and buying government assets.

According to Keynesian, inflation can be caused by increase in demand and/or increase in cost. Demand-pull inflation is a situation where aggregate demand persistently exceeds aggregate supply when the economy is near or at full employment. Aggregate demand could rise because of several reasons. A cut in personal income tax would increase disposable income and contribute to a rise in consumer expenditure. A reduction in the interest rate might encourage an increase in investment as well as lead to greater consumer spending on consumer durables. A rise in foreigners' income may lead to an increase in exports of a country. An expansion of government spending financed by borrowing from the banking system under conditions of full employment is another cause of inflation. An increase in demand can be met initially by utilising unemployed resources if these are available. Supply rises and the increase in demand will have little or no effect on the general price level at this point. If the total demand for goods and services continue to escalate, a full employment situation will eventually be reached and no further increases in output are possible. This leads to inflationary pressures in the economy.
Macro Economics Report Page 37

Demand-pull inflation is caused by excess demand, which can originate from high exports, strong investment, rise in money supply or government financing its spending by borrowing. If firms are doing well, theey will increase their demand for factors of production. If the factor market is already facing full employment, input prices will rise. Firms may have to bid up wages to tempt workers away from their existing jobs. It is most likely that during full employment conditions, the rise in wages will exceed any increase in productivity leading to higher costs. Firms will pass the higher costs to consumers in the form of higher prices. Workers will demand for higher wages and this will add fuel to aggregate demand, which increases once again. The process continues as prices in the product market and factor market are being pulled upwards. Keynesian theory of cost-push inflation attributes the basic cause of inflation to supply side factors. This means that according to Keynesian, rising production costs will lead to inflation. Cost-push inflation is usually regarded as being primarily a wage inflation process because wages usually constitute the greaer part of total costs. Powerful and militant trade unions who negotiate wage increases in excess of productivity are more likey to succeed in their wage claims the closer the economy is to full employment and the greater the problem of skill shortages. An increase in the price of coal, oil and many other basic inputs or even semi-manufactured goods used as component parts in the production process will manifest itself as higher consumer prices. The oil crisis in 19731974 and 1970-80 resulted in many countries experiencing severe cost-push inflation. Inflation may occur when there is a depreciation of the home currency. A depreciation of a country's currency results in increases in the price of imported foodstuff, raw materials and capital equiment which then results in a rise in production costs. A significant increase in the level of indirect taxes(taxes on goods and services) will raise domestic prices independently of the state of demand and could be a causal factor in creating wage-push pressure on the economy. When firms are faced with higher wage costs, they push up the prices of their products to maintain their profits. Sometimes, they may even seize the opportunity to increase their profit margins. The more price inelastic the demand for their goods, the less likely such behaviour will lead to a fall in demand for their products.
Macro Economics Report Page 38

Cost push inflation in inevitable when there is a struggle between workers and firms. Both try to maintain their real incomes by bidding up their wages and profits. Workers force firms to give inflationary pay increases while firms increase prices so as to raise their profit margins. Price rises are inevitable. This process is known as a wage-price spiral. In practice, it may not be easy to identify the primary cause of inflation. Demand pull and cost push inflation can occur together. An initial demand pull inflation may strengthen the power of trade unions which then use this power to drive up costs. Alternatively, an initial cost push inflation may encourage the government to expand aggregate demand to offset rises in unemployment. Once inflation is under way, it is not always easy to identify the underlying cause. Keynes' demand and cost push theories pointed out that the closer the economy is to full employment, the greater the inflationary pressure. The greater the rate of unemployment, the less the inflationary pressure.

Controlling inflation forms a significant part of the economic activities of a nation. Inflation is an economic condition characterized by a general rise in the prices. Thus, controlling Inflation is important as unrestrained increase of the prices may culminate in Hyperinflation, and an excessive fall in the prices may lead to Deflation. Both the situations are not healthy and sound for the overall growth and development of a country's economy. Infect, keeping a strong control over Inflation has turned out to be one of the primary objectives of the governments of different countries across the globe. To this effect, efficacious economic policies are being formulated, which mainly concentrate on the fundamental causes of Inflation in an economy, and try to improvise methods to keep the inflationary conditions under control. For instance, if the primary reason for inflation in a nation is the excessive demand for goods and services, then the economy policy on the government level should find out the causes of such unnecessary rise and undertake measures to decrease the overall level of collective demand .Sometimes, if it is seen that Cost-Push Inflation is responsible for the rise in the demand for goods and services, then the cost of production must be checked, to handle the inflation-related problems.
Macro Economics Report Page 39

Mentioned below are some methods, which have proved to be highly effective in controlling inflation to large extents:

Fiscal policies are effective in increasing the leakage rates from the circular income flow, thereby rejecting all further additions into this particular flow of income. This brings about a reduction in the Demand-Pull Inflation, in terms of increasing unemployment and slackening the economic growths. Following are a few types of fiscal policies commonly employed: • • • Lowering the expenses on governmental level A fall in the borrowing amounts in the government sectors, on an annual basis High direct taxes, for reducing the disposable income.

Monetary policies have a great role to play in controlling Inflation. These are policies which can actually control the rise in demand, by increasing the rates of interest and reducing the supply of real money. An escalation in the interest rates brings about a reduction in collective demands, in the following three ways: • A rise in the interest rate discourages borrowing from both companies and households. When interest rates increase, it simultaneously encourages the saving rate, owing to an escalation in the opportunity cost of expenditure. Rise in the interest rates is a very useful tool for restricting monetary inflation. Increase in the real rates of interest decreases the demands for loans, thereby limiting the growth of broad money. There may also be a fall in the commercial investments, due to a rise in the costs of borrowing money. This exerts a direct influence on a handful of planned investment-related projects, which turn out to be unprofitable. This leads to a fall in the collective demand An increase in the payment of mortgage interests automatically decreases the real 'effective' disposable income of the house owners, as well as their spending capacities. Escalation in the mortgage costs also decreases the demand generated in the housing markets.
Page 40

Macro Economics Report

An escalation in the exchange rate is possible by increasing the rates of interest or buying money through the central band interferences in the foreign exchange markets. Mentioned below is a short-term mean by which inflation can be controlled through exchange rates: • Income policies or direct wage controls: Setting restrictions on the growth rate of wages may decrease cost push inflation. Om governmental level, an attempt to influence the growth of wage leads to limit the rise in the pay in public sectors, as well as initiates cash restrictions for making payments to the employees of public sectors.

As far as the private sector is concerned, the government attempts to convince the commercial firms and its employees to implement self-controls at the time of negotiating wages. Generally, there is a fall in the wage inflation when there is an economic depression, leading to a rise in the unemployment rates. The Long term means of controlling the Inflation are as follows: • Supply-side reform Policy: According to this policy, if more output is produced at a low per unit cost, there are chances for economy to attain persistent economic growth and development, without being affected by inflation. Policy regarding labor market reforms: If an increase in the flexibility of labor market permits the commercial forms to put a check on labor costs, it can lead to a reduction in the pressures created by the CostPush Inflation.

The essence of the Phillips Curve is that there is a short-term trade-off between unemployment and inflation. But the original Phillips Curve has come under sustained attack – in particular from monetarist economists, and when we consider the data for unemployment and inflation in Britain over the last fifteen years, we will find that the nature of the trade-off has certainly changed for the economy and others as well.

The Basic Phillips Curve Idea – Economic Trade-Offs
Macro Economics Report Page 41

In 1958 AW Phillips from whom the Phillips Curve takes its name plotted 95 years of data of UK wage inflation against unemployment. It seemed to suggest a short-run trade-off between unemployment and inflation. The theory behind this was fairly straightforward. Falling unemployment might cause rising inflation and a fall in inflation might only be possible by allowing unemployment to rise. If the Government wanted to reduce the unemployment rate, it could increase aggregate demand but, although this might temporarily increase employment, it could also have inflationary implications in labour and the product markets. The key to understanding this trade-off is to consider the possible inflationary effects in both labour and product markets arising from an increase in national income, output and employment.
The labour market: As unemployment falls, some labour shortages may

occur where skilled labour is in short supply. This puts extra pressure on wages to rise, and since wages are usually a high percentage of total costs, prices may rise as firms pass on these costs to their customers Other factor markets: Cost-push inflation can also come from rising demand for commodities such as oil, copper and processed manufactured goods such as steel, concrete and glass. When an economy is booming, so does demand for these components and raw materials. Product markets: Rising demand and output puts pressure on scarce resources and can lead to suppliers raising prices to widen profit margins. The risk of rising prices is greatest when demand is out-stripping supplycapacity leading to excess demand (i.e. a positive output gap)

Explaining the Phillips Curve concept using AD-AS and the output gap
Let us consider the explanation for the trade-off using AD-AS analysis and the concept of the output gap. In the next diagram, we draw the LRAS curve as vertical - this makes the assumption that the productive capacity of an economy in the long run is independent of the price level. We see an outward shift of the AD curve (for example caused by a large rise in consumer spending) which takes the equilibrium level of national output to Y2 beyond potential GDP Yfc. This creates a positive output gap and it is this that is thought to cause a rise in inflationary pressure as described above. Excess demand in product markets and factor markets causes a rise in production costs and this leads to an inward shift in short run aggregate supply from SRAS1 to SRAS2. The fall in supply takes the economy back
Macro Economics Report Page 42

towards potential output but at a higher price level.

So this might help to explain the Phillips Curve idea. We could equally use a diagram that uses a non-linear SRAS curve to demonstrate the argument. The next diagram shows the original short-run Phillips Curve and the tradeoff between unemployment and inflation:

The Expectations-Augmented Phillips Curve
The original Phillips Curve idea was subjected to fierce criticism from the Monetarist economic school among them the American economist Milton
Macro Economics Report Page 43

Friedman. Friedman accepted that the short run Phillips Curve existed – but that in the long run, the Phillips Curve was vertical. In other words, Friedman argued that in the long run, there was no trade-off between unemployment and inflation. He argued that each short run Phillips Curve was drawn on the assumption of a given expected rate of inflation. So if there were an increase in inflation caused for example by a temporary boost to aggregate demand caused by a large monetary expansion and this had the effect of driving inflationary expectations higher, then this would cause an upward shift in the short run Phillips Curve. The Monetarist view is that attempts to boost AD artificially to achieve faster growth and lower unemployment have only a temporary effect on unemployment. Friedman argued that a government could not permanently drive unemployment down below the NAIRU – the result would be higher inflation which in turn would eventually bring about a return to higher unemployment but with inflationary expectations increased along the way. Friedman introduced the idea of adaptive expectations – if people see and experience higher inflation in their everyday lives, they come to expect a higher average rate of inflation in future time periods. And they (or the trades unions who represent them) may then incorporate these changing expectations into their pay bargaining. Wages often follow prices. A burst of price inflation can trigger higher pay claims, rising labour costs and further upward pressure on the market prices of many different goods and services. This is illustrated in the next diagram – inflation expectations are higher for SPRC2. The result may be that higher unemployment is required to keep inflation at a certain target level.

Macro Economics Report

Page 44

The expectations-augmented Phillips Curve argues that attempts by the government to reduce unemployment below the natural rate of unemployment by boosting aggregate demand will have little sustained success in the long run. The effect is to create higher inflation and with it an increase in inflationary expectations. The Monetarist school believes that inflation is best controlled through tight control of money and credit. Credible policies to keep on top of inflation can also have the beneficial effect of reducing inflation expectations – causing a downward shift in the short run Phillips Curve.
The Long Run Phillips Curve

Normally drawn as vertical – but the long run curve can shift inwards over time.

Macro Economics Report

Page 45

An inward shift in the long run Phillips Curve might be brought about by supply-side improvements to the economy – and in particular a reduction in the natural rate of unemployment. For example labour market reforms might be successful in reducing frictional and structural unemployment – perhaps because of improved incentives to find work or gains in the human capital of the workforce that improves the occupational mobility of labour.

Macro Economics Report

Page 46

1. www.economicshelp.org/.../inflation/different-types-of-inflation 2. www.economywatch.com/inflation/causes.html 3. www.economywatch.com/unemployment/measurement.html 4. tutor2u.net/economics/content/topics/.../unemp_policies.html 5. http://tutor2u.net/economics/revision_focus_2004/A2_The_Phillips_Curve.pdf
6. http://tutor2u.net/economics/revision-notes/a2-macro-phillips-curve.html 7. http://www.britannica.com/EBchecked/topic/456596/Phillips-curve 8. http://www.opfblog.com/8447/inflation-and-its-impact-on-the-pakistan-economy

9. http://www.infocheese.com/expectationsaugmentedphillipscurve.html

Macro Economics Report

Page 47

Master your semester with Scribd & The New York Times

Special offer for students: Only $4.99/month.

Master your semester with Scribd & The New York Times

Cancel anytime.