LESSON 4

INFLATION AND UNEMPLOYMENT

STRUCTURE

4.1 Objective
4.2 Introduction
4.3 Inflation and Interest Rates- Fisher Equation
4.4 Social Cost of Inflation
4.5 Concept of Unemployment
4.6 Summary
4.7 Self Assessment Questions
4.8 Suggested Readings

4.1 OBJECTIVE

After reading this lesson, you should be able to

a) Explain the concept of Inflation and Unemployment
b) Understand the different costs associated with Inflation
c) Differentiate between different types of Unemployment.
d) Analyze strategies to reduce inflation
e) Explain and analyze the wait unemployment

4.2 INTRODUCTION

A situation that affects all the economies of the world is the changes in the price level which can
be either increase or decrease in prices. The former one where there is persistent and
considerable increase in the prices is known as inflation. It affects the standard of living of the
people of an economy as it reduces there real income or the purchasing power. Some percentage
of inflation is bound to exist in an economy that is expanding or growing. Its opposite is known
as Deflation which means a reduction in the price level in an economy. One should not be
confused between deflation and Disinflation as the latter one means there is inflation in the
economy but its rate has reduced. Various economists have tried to analyse the relation between
inflation and interest rates and one equation which is of utmost importance is given by Fisher
that would be taken up in the chapter. Another feature that is common in all the economies of the
world is the problem of unemployment. It refers to a situation where people who are able and
willing to work are unable to find a job at the prevailing wage rates. Again some percentage of
unemployment is bound to be present in all the economies because of people changing jobs and
other reasons. But still if unemployment is huge and chronic it is devastating for any economy.
So the various types and causes of unemployment too would be taken up in this chapter.

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4.3 INFLATION AND INTEREST RATES- FISHER EQUATION

Fisher effect is a theory propounded by economist Irvin Fisher that explains the relation between
inflation and interest rates – both real and nominal. Nominal interest rate is the rate that prevails
in the market whereas real interest rate shows change in the purchasing power. Fisher provided
that expected real interest rate can be calculated by deducting the expected rate of inflation from
the expected nominal rate of interest. For example, if the nominal interest rate on a savings
account is 6% and the expected rate of inflation is 3%, then the money in the savings account is
really growing at 3%. The smaller the real interest rate the longer it will take for savings deposits
to grow substantially when observed from a purchasing power perspective. It can be presented in
the following equation:

re = i - πe
Where re = Expected Real interest rate

i = Nominal rate of interest and

πe = Expected rate of inflation

This equation holds in the short run as the changes in nominal rate of interest takes place because
of changes in real interest rate and expected inflation. In the long run however if the real interest
rate is assumed to be constant and expected inflation is equal to actual inflation because the
economy is operating at full employment level of output the above equation changes as:

r* = i - π
Where r* = Given real interest rate

i = Nominal rate of interest and

π = Actual rate of inflation

Thus in the long run the changes in inflation are shown in the nominal rate of interest. It is called
Fisher’s Effect. The Fisher effect is more than just an equation: It shows how the money supply
affects nominal interest rate and inflation rate

4.4 SOCIAL COST OF INFLATION

Inflation refers to persistent and considerable increase in the prices in an economy such that the
real income of the people of that economy reduces. However if there is an increase in price
which is either not significant or not continuous then it cannot be termed as inflation. Inflation
can be of various degrees depending upon its intensity like:
1. Creeping, Mild or Low Inflation: It is the mildest form of inflation where rate of increase in
prices is very low that is not more than 3% per annum then it is called creeping inflation.

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2. Chronic or Secular Inflation: When creeping inflation continues for a long period of time it
takes the form of chronic inflation. It is named chronic because if an inflation rate continues to
grow for a longer period without any downturn, then it possibly leads to Hyperinflation.
3. Walking or Trotting Inflation: When the rate of increase in prices is more than 3% per annum
but less than 10% per annum it is termed as walking inflation. It should be corrected in time as
otherwise it may lead to serious consequences.
4. Moderate Inflation: Prof. Samuelson clubbed together concept of Creeping and Walking
inflation into Moderate Inflation. It happens when prices rise by less than 10% per annum (single
digit inflation rate). According to him, it is a stable inflation and not a serious economic problem.
5. Running Inflation: When prices rise at a fast rate that is more than 10% per annum it is termed
as running inflation as rate of increase in prices is in double digits which is not good for the
economy.
6. Galloping or Jumping Inflation: According to Prof. Samuelson, if prices rise by dual or triple
digit inflation rates like 30% or 400% or 999% yearly, then the situation can be termed as
Galloping Inflation. When prices rise by more than 20%, but less than 1000% per annum (i.e.
Between 20% to 1000% per annum), Galloping Inflation occurs. Jumping Inflation is its another
name.
7. Hyperinflation: When rate of increase in prices takes an alarming situation it is termed as
hyperinflation and it is beyond the corrective action of any government. When prices rise above
1000% per annum (quadruple or four-digit inflation rate), it is termed as Hyperinflation. During
a worst-case scenario of hyperinflation, the value of the national currency (money) of an affected
country reduces almost to zero. Paper money becomes worthless, and people start trading either
in gold and silver or sometimes even use the old barter system of commerce. Two worst
examples of hyperinflation recorded in the world history are of those experienced by Hungary in
the year 1946 and Zimbabwe during 2004-2009 under Robert Mugabe's regime.
Inflation which is a general and persistent rise in the prices over a considerable period of time
can be divided into perfectly anticipated inflation and imperfectly anticipated inflation. The types
of inflation based on the expectation or predictability:
Anticipated Inflation: If the rate of inflation corresponds to what the majority of people are either
expecting or predicting, then is called Anticipated Inflation. Expected Inflation is it’s another
name.
Unanticipated Inflation: If the rate of inflation corresponds to what the majority of people are
neither anticipating nor predicting, then is called Unanticipated Inflation. Unexpected Inflation is
it’s another name.
Costs of Perfectly Anticipated Inflation
1. Shoeleather Cost: A high anticipated inflation means a higher nominal rate of interest as
shown by the above Fisher equation which means people hold less money with them as
the opportunity cost of holding money is quite high thus making frequent visits to the
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 banks. This inconvenience of reducing money holding is called the shoe-leather cost of
inflation. This cost of wearing out of one’s shoes while making frequent trips to banks
because of reduced money holding is called the shoe leather cost of inflation.
2. Menu costs: When inflation is high then it increases the cost of production of the firms
which forces the firms to change their prices often which is costly as it involves printing
of new catalogues, packaging that has prices printed on them. This increased cost of
frequent printing of menus is known as menu cost that arises because of high anticipated
inflation.
3. Microeconomic Inefficiencies: As the firms’ menu changes frequently because of
changes in the prices the variability in relative prices is quite high and it bring difficulty
in market allocations as it is based on relative prices thus bringing inefficiency in the
resource allocations.
4. Tax Issues: Inflation affects the tax liability of individuals and companies that are not
taken care of in the tax rules. As inflation changes the nominal income there is change in
the tax liability irrespective of the fact whether real income has changed or not. Thus it
again brings inefficiency if it is not taken care of in the tax rules.
5. Inconvenience: Money is common measure of value, it is the yardstick to measure
economic transactions but when the worth of the yardstick itself is changing it brings
distortions in measuring the economic worth or value of different transactions
6. Reduced Purchasing Power: If nominal income changes at the same rate as that of the
inflation then there is no change in the real income as shown by Fisher equation in the
long run, however if inflation and nominal income do not keep pace then there might be a
reduction in the purchasing power.
7. Fiscal Drag: With rising income because of inflation more people fall in the higher tax
brackets, thus the amount of tax per person increases and they are dragged into tax
payments because of higher inflation.
If inflation is unanticipated (e.g. people expect a lower inflation rate) then the costs will be
more serious than if the inflation rate was expected. It is unanticipated inflation that can
negatively impact on a firm’s costs.
Costs of Unanticipated Inflation
Unanticipated inflation has effects that are far worse then the inflation which was correctly
anticipated in advance. Unanticipated inflation arbitrarily redistributes income and wealth among
individuals. This brings losses to one and gains to other and it is something which was not
expected in advance, it can be understood with a simple loan example where the interest rates
were fixed in advance which was based on an anticipated inflation rate. The ex post real return
that the debtor pays to the creditor differs from what both parties anticipated. Now here if
inflation is higher than what was anticipated the debtor is at a gain as he pays a lesser sum in
terms of real balances as interest rate was fixed based on a lower anticipated inflation rate and

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creditor loses as he gets less. The opposite would be true if the actual inflation is les than the
anticipated inflation. Thus it brings wealth distribution distortions.

4.5 CONCEPT OF UNEMPLOYMENT

Unemployment is a situation where a person who is able and willing to work is unable to find a
work at the prevailing wage rate. Unemployment is considered to be a measure that reflects the
health of an economy. There are various types of unemployment that are prevalent. They have
been defined as:
1. Voluntary Unemployment: When unemployment arises out of individual’s own choice
and not because there no jobs available in the economy, it is known as voluntary
unemployment. The reason can be search of better job prospects. Here the reservation
wage rate of the worker (the minimum price that a worker desires to get) is more then the
prevailing wage rate. Such people are not included in the labour force of the economy as
they are finding the suitable work but still not willing to work.
2. Involuntary Unemployment: when a person is willing to work at the prevailing wage rate
but is still unable to find a job it is termed as involuntary unemployment. These people
are physically and mentally fit to do a job and ready to accept the prevailing wage rates
but still out of work force because of low demand of labour.
3. Frictional Unemployment: Sometimes workers leave their present job to find a better one
and for a temporary period when they are unemployed it is called frictional
unemployment. It can be a voluntary one or also a termination though the previous one is
more common. Some percentage of unemployment in the form of frictional is always
present in all the economies. Though it is short term but is usually unavoidable. Frictional
unemployment usually reduces in times of recession as the basic reason behind friction is
better job prospects but during recession as already fewer jobs are there so workers are
contend with their present jobs.
4. Cyclical Unemployment: Every economy goes through boom, recession, recovery etc.
When there is unemployment in the economy because of downturn in the business cycle
which can be measured by reduction in GDP it is called cyclical unemployment. It is
usually a long term phenomenon. It's known as “cyclical” because it’s tied to the business
cycle. It is one of the major reasons behind high unemployment in any economy.
5. Structural Unemployment: The unemployment that arises because a type of technology
becomes outdated and employees are unemployed. Structural unemployment is a
permanent level of unemployment that's caused by forces other than the business cycle. It
occurs when an underlying shift in the economy makes it difficult for some groups to find
jobs. There is a mismatch between the jobs available and the skill levels of the
unemployed. It is harder to correct than other types of unemployment.
6. Disguised unemployment: This type of unemployment is usually found in agriculture
where more people are unemployed then are actually efficiently required, though it
appears that they all are employed but the marginal productivity of many is either zero or

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 negative and hence it called disguised unemployed as on the face of it they seem to be
employed.
7. Natural Rate of Unemployment: Some unemployment is bound to be there in every
economy because of frictional unemployment or structural unemployment. This is known
as natural rate of unemployment. The Natural Rate of Unemployment is sometimes
known as the Non accelerating inflation rate of Unemployment NAIRU. This is because
when unemployment is at natural rate there is no tendency for inflation to increase.
8. Wait Unemployment: Unemployment caused when workers are rigid about wages which
are above the equilibrium wage rate. It can be explained with the following figure:

Figure 1
Here DL is the demand curve of labour which is downward sloping showing inverse relation
between wage rate and demand of labour by the firms. SL is the supply curve of labour
which here is assumed to be constant showing full employment level as per classical theory.
Now as per the equilibrium achieved by intersection of demand and supply curve of labour
the wage rate that should prevail is W1 but if the workers are rigid about wages at W* then at
increased wage rate the demand for labour would be more than the supply of labour and it
leads to wait unemployment arising because of rigid wages.
Various causes that can be associated with Wait employment are:
1. Minimum Wage Laws – Government of various countries impose a floor price on the
wages that can be paid to the workers of the economy. These wages are usually above the
equilibrium wage rate. It reduces the demand of workers thereby creating an excess
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 supply and leading to wait unemployment because of rigidity of wages. Another reason
for this type of unemployment can be presence of trade unions.
2. Trade Unions: Presence of trade unions also leads to wage rigidity and hence wait
unemployment this is because trade unions often bargain for a higher wage rate then the
equilibrium wages and it also creates excess supply and wait unemployment.
Exercise 1: What are the determinants of Unemployment.
Solution: Let E = Total workers Employed
U = Total workers unemployed
L = Total Labour force that includes both employed and unemployed
If we assume that there is steady state of employment then people who are leaving the jobs in
search of new jobs should be exactly equal to those who are finding the jobs such that:
fU = sE where
f is rate of job finding and U is unemployed workers so fU is total number of workers finding
the job out of the unemployed pool. Similarly s = rate of job separation that is people who are
leaving the job out of those who are employed
So to be in steady state they should both match each other..Thus the equation that we get is:
L=E+U
E=L-U
Also fU = sE, fU = s (L – U)
Dividing both sides by L we get
fU/L = s (L – U)/L
fU/L = s (1- U /L)

fU/L + sU/L = s, U/L (f + s) = s, U/L = s/s+f

Above equation shows relation between unemployment rate that is U/L and rate of job
separation and job finding. Following results are obtained
1. Unemployment rate is directly related to job separation that is higher the job separation or
frictional unemployment higher is the unemployment.
2. Unemployment rate is inversely related to job finding that is higher the job finding lower
is the unemployment

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4.6 SUMMARY

Two major issues that every economy faces today are that of unemployment and inflation. These
are two issues that every government wants to reduce that is to have lower unemployment and
lower inflation. However there is a trade off between the two so the government has to accept
one of the evils. Inflation means persistent and considerable increase in the prices that reduce the
purchasing power of money whereas unemployment refers to a situation where able and willing
people are unable to find a job at the existing wage rates. There are various types of
unemployment that prevail in any economy at a point of time, some of them being short term
while others are chronic or long term in nature. Some causes of unemployment can be slow
economic growth where economy is growing at a slower rate as compared to growth in the
working population leading to surplus labour force being unemployed, joint family system
provides support to the family members who are unemployed thereby reducing the urge amongst
others to work, slow growth of industries also contribute to the unemployment as industries are
unable to add enough jobs to support the growing population, less savings and investment leads
to reduction in capital formation that aggravates the problem of unemployment. Though it is
impossible to have zero level of unemployment but still it should be reduced to the bare
minimum to make efficient use of the human resource of an economy.

4.7 SELF ASSESSMENT QUESTIONS

Check your progress

Exercise 1: True and False
(a) Unemployment means hundred percent employment.
(b) Disguised unemployment means more people working than are actually required.
(c) A two sector Economy is also called open economy.
(d) There is a trade off between unemployment and inflation.
(e) Frictional unemployment is chronic unemployment.
(f) Equilibrium level of output depends on the slope of Aggregate demand curve
Ans. 1(F), 2(T), 3(F), 4(T), 5(F), 6(T)
Exercise 2: Fill in the Blanks
(a) Cyclical unemployment occurs because of _ _ _ _ _ _ _ _ _ .
(b) If unemployment is high inflation would be _ _ _ _ _ _ _ _ _ .
(c) Unemployment present in every economy is _ _ _ _ _ _ _ _ .
(d) Fisher effect shows relation between _ _ _ _ _ _ and _ _ _ _ _ _ .
Ans 1. Business Cycles 2. Low 3. Natural Rate of Unemployment 4. Inflation and Interest Rate
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Exercise 3: Questions
1. Explain the Fisher. effect both in short term and long term
__________________________________________
__________________________________________

2. What are the different types of Unemployment.

__________________________________________
__________________________________________

3. What are the main causes of Wait unemployment

__________________________________________
__________________________________________

4. Explain the concept of automatic stabilizers by giving suitable example.

__________________________________________
__________________________________________

5. Explain the relation between inflation and unemployment.

__________________________________________
__________________________________________

6. Explain the concept of Natural rate of Unemployment.

__________________________________________
__________________________________________

7. What is the difference between voluntary and involuntary unemployment.

__________________________________________
__________________________________________

8. How can unemployment be reduced in an economy.

__________________________________________
_______________________________________________

4.8 SUGGESTED READINGS

Mankiw, N. Gregory, Macro Economics, Macmillan Worth Publishers New York, Hampshire
U.K..
Dornbusch, Rudiger and Stanley, Fischer, Macro Economics Theory, McGraw-Hill
Barro Robert J., Macroeconomics Theory and Applications, MIT Press.

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 LESSON 5
INFLATION AND UNEMPLOYMENT (PART 2)

STRUCTURE

5.1 Objective
5.2 Introduction
5.3 Philips Curve and Modern Philips Curve
5.4 Aggregate Supply Curve and Dynamic Aggregate Supply Curve
5.5 Neutrality of Money
5.6 Dynamic aggregate Demand Curve
5.7 Gradualism and Cold Turkey
5.8 Summary
5.9 Self Assessment Questions
5.10 Suggested Readings

5.1 OBJECTIVE

After reading this lesson, you should be able to

a) Explain the relation between unemployment and wage inflation
b) Explain the relation between price level and equilibrium level of output
c) Analyze the impact of expected inflation on output
d) Examine the relation between inflation and equilibrium level of output
e) Show the impact of monetary expansion on real money supply

5.2 INTRODUCTION

The previous chapter talked about relation between interest and inflation both in the short run
and long run using Fisher equation. It also discussed various types of unemployment present in
an economy, their causes and effects. The present chapter would focus on different types of
theories given by different economists showcasing relation between inflation, employment,
unemployment and equilibrium level of output. A.W Philips started out with explaining why
there is inverse relation between unemployment and growth rate in wages which was further
extended to explain the relation between unemployment and price inflation. Later other
economists added the concept of expected inflation to explain the relationship when the previous
one was not sufficient to explain different relationships. The chapter also discusses about why an
increase in nominal money supply has no impact on the real money balances in the long run
showing that money is neutral in the long run. Lastly the chapter would discuss two important
techniques used by government to reduce the level of expected inflation namely Gradualism and
Cold Turkey.

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5.3 PHILIPS CURVE AND MODERN PHILIPS CURVE

Philips curve was given by economist A.W. Philips to establish the relationship between level of
unemployment in an economy and growth rate in wages. Phillips analyzed annual wage inflation
and unemployment rates in the UK for the period 1860 – 1957, and then plotted them on a scatter
diagram. The data appeared to demonstrate an inverse and stable relationship between wage
inflation and unemployment. Later on it was used to explain the relation between unemployment
and general price inflation instead of wage inflation. Normally an economy desires to have low
unemployment and low inflation but this curve showed that there is a trade off that is if there
high unemployment then there would be reduction in wages and reduced wage inflation and vice
versa. Thus Philips curve helps an economist in deciding the different combination of inflation
and interest rate that it can have. It can be derived mathematically as:
Growth rate in wages: Gw = W-W-1/W-1
Also there being inverse relation between growth rate in wages and unemployment it can be
rewritten as:
Gw = -θ (u – u*) where Gw = Growth rate in wages, θ = Functional relationship between wage
inflation and unemployment, u = actual unemployment and u*= natural rate of unemployment.
Equating above two equations we get:
W-W-1/W-1 = -θ (u – u*), W = W-1 [1- θ (u – u*)]
Philips curve depicted that wages and prices adjust slowly to changes in demand in the economy
that is prices and wages are sticky in the short run. The relationship can be shown
diagrammatically as:

Figure 1: Philips Curve

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The above curve thus shows different combinations of unemployment and wage inflation than an
economy can opt for, there being a trade off between the two.
The above relation can also be extended to show the relation between employment and growth
rate in wages. As there is inverse relation between unemployment and wage inflation there is
bound to be direct relation between wage inflation and employment which can be shown
mathematically as:
Rate of unemployment, u – u* = E* - E/E* where E* = Full employment level and
E= Actual employment , substituting value of unemployment in Philips curve equation above we
get:
W = W-1 [1- θ (E* - E/E*)], W = W-1 [1 + θ (E – E*/E*)],
Thus it shows there is direct relation between change in the wages and employment.
When the above Philips curve was applied to economies like United States and Britain it was
found that it failed to be tested empirically and hence economists thought of something that was
missing in the original Philips curve. The missing link was found out to be expected inflation.
Friedman and Phelps introduced an adjustment in Phillips curve with respect to anticipated or
expected inflation (πe) as a factor influencing the growth rate of money wage. As the modern
Phillips curve incorporates the expected inflation, therefore, when workers and firms enter into
wage negotiations while fixing the wage and price they bargain over the real wages, and both
sides are willing to adjust nominal wage for any inflation expected during the contract period.
Thus Modern Philips curve shows that actual inflation is actually effected by expected inflation
as well as unemployment level. It states that workers are not concerned about nominal wages but
real wages and want them to be constant such that any change in actual or expected inflation is
shown in the nominal inflation so that there purchasing power is constant. So modifying the
original Philips curve equation to include expected inflation we get the following equation:

Gw = -θ (u – u*) + πe as wages would grow by an equal amount as the changes in inflation so Gw

= π, the above equation can be rewritten as:

π = πe - θ (u – u*) Thus the modern Philips curve in the short run can be drawn as:

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 Figure 2
The above figure shows that if actual unemployment is equal to natural rate of unemployment
then actual inflation is equal to expected inflation. M1 is drawn corresponding to an expected
inflation which is low whereas M2 is drawn with an expected inflation that is more. Thus higher
expected inflation means a greater intercept and lower expected inflation means a lower curve. a
point where there is high expected inflation and high unemployment is known as stagflation
which is shown by a point towards the right of u* and on M2 curve.

5.4 AGGREGATE SUPPLY CURVE AND DYNAMIC AGGREGATE SUPPLY

CURVE

The curve that shows the relation between price level and equilibrium level of output is known as
the aggregate supply curve. It can be derived mathematically as:
Let the production function is given by:
Q = pE where Q = Total Output, p = efficiency of labour and E = total employment
Now to establish the price we add profit margin to the unit cost and assuming that labour cost is
the major cost, we get the following:
P = (1+z)W/E where Z is the mark up cost and W is the current periods wages.
Now substituting the above in the Philips curve equation we get:
W = W-1 [1 + θ (E – E*/E*)], P = (1+z)/E W-1 [1 + θ (E – E*/E*)]

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P = P-1 [1 + θ (E – E*/E*)], P = P-1 [1 + θ (Q – Q*/Q*)], P = [1 + α ( Q-Q* )]
This is the equation of the aggregate supply curve showing positive relation between equilibrium
level of output and current price level. It can be plotted as follows:

Figure 3
There can be three situations here; if actual output is equal to full employment level of output
then the current price would be equal to previous period’s price level. If however the output is
more than the full employment level then current price level would be more than the previous
period’s prices and there would be a movement to point B in the short run whereas in the long
run the aggregate supply curve would shift upwards. The opposite would happen if the actual
output is less than the full employment level of output. The slope of the aggregate supply curve
is dependent on the slope variable given by ‘α’. The position depends on the past periods price
level. There were certain limitations in the aggregate supply curve hence it laid way for the
modified aggregate supply curve which took into consideration the expected inflation too.
Inflation that is π can be calculated as:
π = P – P-1/P-1
So the above aggregate supply equation can be rewritten as:
π = α ( Q – Q*) This is the modified aggregate supply curve which shows relation between
inflation and output. If expected inflation is added to it then it becomes expectations augmented
aggregate supply curve or dynamic aggregate supply curve which can be written as:
π = α ( Q – Q*) + πe

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The equation above shows that actual inflation is dependent on not only the level of output but
also on the expected inflation and there is one to one relation between the expected inflation and
actual inflation apart from the level of output. This is dynamic aggregate supply curve.

5.5 NEUTRALITY OF MONEY

Neutrality of money shows how expansion in money supply impacts the equilibrium level of
output in the short run, medium term and long term. Money supply has an impact on the output
in the short term but not in the long term it is because changes in the money supply growth will
lead to changes in the GDP growth only when there is no change in the price level and as per
Philips curve prices are sticky in the short run, thus nominal money supply change lead to real
money supply change which then stimulates the output. In the long run, however, prices adjust
and three is no impact on real money supply and real GDP. In other words, money has neutral
impact on all real macro variables. It can be shown graphically as:

Figure 4
Original aggregate demand curve is AD and aggregate supply curve is AS where original
equilibrium is at E having full employment level of equilibrium and current price is equal to past
periods prices. Now if there is an increase in money supply then aggregate demand curve shifts
to right and new equilibrium is at E’ where output becomes more than the full employment level
in the short run and price level also increases. This process cannot continue in the long as output
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cannot be more or less than the full employment level. So in the medium term the adjustment
process would start and there would be an increase in the prices that reduces the aggregate
supply and AS curve shifts up to the left with new equilibrium at lesser output and increased
prices, this process continues in the long run till the prices have increased to such an extent that
the output comes back to Y* and there is no change in the real money supply as price level has
increased by the same proportion as the money supply thereby having the same level of real
money supply and making money neutral in the long run having no impact on the level of output.
It shows that though in the short run and medium run the money supply is not neutral it impacts
the output; in the long run money supply has no impact on real variables.

5.6 DYNAMIC AGGREGATE DEMAND CURVE

In unit 2 of IS-LM model we talked about derivation of aggregate demand curve that showed
relation between price level and equilibrium level of output such that both the goods market and
money market are in equilibrium but now here we are going to explain the derivation of dynamic
aggregate demand curve that talks about relation between inflation rate and equilibrium level of
output. It can be derived from IS-LM equations as follows:
Equilibrium in Goods market is when Y= AD which can be further elaborated as:
Y = mg (A – ai) where mg = Government multiplier, A = Autonomous spending, a = sensitivity
of investment to rate of interest and i = real rate of interest
Also i = r – π , substituting this in equation above we get:
Y = mg [A – a (r– π)], Y = mg [A – ar + aπ)],
Money market is in equilibrium when money demand = money supply
r = 1/h [kY – M/P], Simultaneous equilibrium is when IS = LM
Y = mg [A – a/h (kY – M/P) + aπ)], Above equation shows that the output is affected because of
autonomous spending, real money supply and inflation rate.
Above equation can be modified to explain the aggregate demand equation as:
∆Y = αf + φ (m – π) or Y – Y-1 = αf + φ (m – π), Y = αf + φ (m – π) + Y-1
π = m – 1/ φ [ Y – Y-1 ]
It shows inverse relation between inflation and equilibrium level of output keeping the nominal
money supply and lagged output as constant. It can be plotted as:

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 Figure 5

DAD is the original demand curve which is at a lower intercept because of lower money supply
and lagged level of output. If there is a change in either of the two variables then the DAD curve
shifts and it would shift up with an increase in nominal money supply.

5.7 GRADUALISM AND COLD TURKEY

Inflation is steady and persistent increase in the prices of the commodities that reduces the
purchasing power in an economy. Though some percentage of inflation is bound to be present in
any economy but still every economy wants it to be in a certain limit. If inflation goes above that
there are two strategies that government can adopt which can be called gradualism or cold
turkey. In gradualism government cuts the nominal money supply by a small amount whereas in
cold turkey the cut in the money supply is drastic. The cut being small in gradualism there is
unemployment and recession but it is not that huge whereas in cold turkey the unemployment
and recession is quite large. Gradualism is mainly adopted by the economies because of its lesser
serious impacts as compared to cold turkey. Both can be presented diagrammatically as:

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 Figure 6: Gradualism
Initial dynamic aggregate demand curve and dynamic aggregate supply curve intersect at e
where actual inflation is much higher then the expected inflation of π’. If government wants to
reach the expected inflation it cuts the money supply by a small amount such that DAD shifts
leftwards with new equilibrium at lower inflation and a new output. With reduction in inflation
the SAS also shifts to right, the process keeps on repeating till the inflation is reduced to the
expected one and output is at full employment level.

Figure 7: Cold Turkey

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Initial dynamic aggregate demand curve and dynamic aggregate supply curve intersect at e
where actual inflation is much higher then the expected inflation of π’. If government wants to
reach the expected inflation it cuts the money supply by a drastic amount such that DAD shifts
leftwards by a huge amount as compared to small magnitude in gradualism with new equilibrium
at lower inflation and a new output. With reduction in inflation the SAS also shifts to right, the
process keeps on repeating till the inflation is reduced to the expected one and output is at full
employment level. Here the expected inflation is reached earlier as compared to gradualism as
the money supply is cut by a huge amount.

5.8 SUMMARY

In the previous chapter we discussed about unemployment its different types and problems
associated. One major problem with unemployment is that it brings changes in prices that bring
changes in inflation. This chapter talked about impact of inflation on unemployment and
employment. Philips curve showed the impact of unemployment on growth rate in wages which
was later changed to price inflation. It stated that prices and wages are sticky in the short run. It
also laid foundation for the development of aggregate supply curve that showed the relation
between price level and equilibrium level of output. However modern economists modified both
the Philips curve and aggregate supply curve to include the component of expected inflation that
was missing in the original research. This is known as expectations augmented Philips curve and
expectations augmented Aggregate Supply Curve. The chapter also discussed about how money
is neutral in the long run having no impact on the real output level as price level increases by the
same quantum by which the money supply increased thereby having no impact on the real GDP.
Every economy in the world wants to attain low level of unemployment and low inflation but
there is a trade off between the two where it has to accept one of the two evils. Though there are
certain strategies that can help in the reduction of the inflation namely gradualism and cold
turkey. Both are different in their approach and impact as the prior one brings smaller changes in
money supply to reduce inflation gradually the second one is concerned about huge changes in
money supply that drastically reduces the inflation and unemployment.

5.9 SELF ASSESSMENT QUESTIONS

Check your progress

Exercise 1: True and False
(a) Unemployment and growth rate in wages have inverse relationship.
(b) Dynamic aggregate Supply curve shows vertical curve.
(c) Philips curve is flatter at the bottom
(d) There is a trade off between unemployment and inflation.
(e) Money is neutral in the long run but not in short term.
(f) Equilibrium level of output depends on the slope of Aggregate demand curve
Ans. 1(T), 2(T), 3(T), 4(T), 5(T), 6(T)

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Exercise 2: Fill in the Blanks
(a) Philips curve shows _ _ _ _ _ _ _ _ _ relation between unemployment and growth rate in
wages.
(b) If unemployment is high inflation would be _ _ _ _ _ _ _ _ _ .
(c) Cold Turkey means _ _ _ _ _ _ _ _ reduction in money supply.
(d) Fisher effect shows relation between _ _ _ _ _ _ and _ _ _ _ _ _ .
Ans 1. Inverse 2. Low 3. Drastic 4. Inflation and Interest Rate
Exercise 3: Questions
1. Explain the derivation of dynamic demand curve.
__________________________________________
__________________________________________

2. What are the different ways to reduce inflation.

__________________________________________
__________________________________________

3. What are the ways through which investors estimate expected inflation
__________________________________________
__________________________________________

4. Explain the concept of automatic stabilizers by giving suitable example.

__________________________________________
__________________________________________
5. Explain the relation between inflation and employment.
__________________________________________
__________________________________________
6. Differentiate between Cold Turkey and Gradualism.
__________________________________________
__________________________________________
7. Derive modified Philips curve from the traditional Philips curve and comment why they are
different.
__________________________________________
__________________________________________
8. Derive expectations augmented aggregate supply curve from the modified aggregate supply
curve.
__________________________________________
_______________________________________________

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5.10 SUGGESTED READINGS

Mankiw, N. Gregory, Macro Economics, Macmillan Worth Publishers New York, Hampshire
U.K..
Dornbusch, Rudiger and Stanley, Fischer, Macro Economics Theory, McGraw-Hill
Barro Robert J., Macroeconomics Theory and Applications, MIT Press.

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