Inflation and Unemployment

Inflation and Unemployment are

issues of national concern. Both
inflation and unemployment should
be avoided as much as possible. It is
essential to have a better
understanding of the relative costs of
both of them to have a better tradeoff.
It is obvious that policymakers would
pick the lowest – combination of
unemployment and inflation
 Phillips Curve
The inverse relationship between unemployment and nominal
wages is known as the Phillips Curve. However, Milton
Friedman and Edmund Phelps argued that a negative
relationship exist between unanticipated inflation and cyclical
unemployment. Changes in either expected inflation or the
natural unemployment rate will shift the Phillips Curve.
Supply shock, an economic disturbance will affect the Curve
too
 Supply shocks: caused by a rise in the cost of oil, imported
raw materials, or domestic wage costs per unit of output.
When supply shock is not accommodated, it is called non –
monetary accommodation. If it is accommodated it is the case
of monetary accommodation. The latter can return the
economy to potential GDP relatively quickly, but at the cost
of a once-and-for-all increase in the price level
 A repeated supply shock, assume that powerful unions are
able to raise money wages faster than productivity , even in
the face of a significant excess supply of labor. Firms then
pass these higher wages on in the form of higher wages. This
type of supply shock is called wage-cost push inflation—
an increase in the price level arising from increases in money
wages that are not associated with excess demand.
 Demand Shocks: caused by an increase in spending and
relaxation of monetary policy. This cause the price and
output to rise. If the monetary authorities react to this, it is
called validating the shock; if it does not, it is called no
monetary validation. The former turns what would have
been a transitory inflation into a sustained inflation
fuelled by monetary expansion
o Sacrifice Ratio
The sacrifice ratio is the percentage of output lost for
each 1 point reduction in the inflation rate. The sacrifice
ratio varies from time to time and from place to place, as
well as in terms of methods used to reduce inflation.
Reasonable estimates range from 1 to 10.
o Costs of Unemployment
There are two main costs of unemployment:
 Lost production

The largest single cost of unemployment is lost

production. Unemployed persons don’t produce though
they have productivity. High unemployment makes social
pie smaller. The cost of the lost output is very high. A
recession can easily cost 3 to 5 % of GDP amounting to
losses measured in hundreds of dollars. Okun’s law states
that 1 extra point of unemployment costs 2 % of GDP
 Effects on the Distribution of Income

The costs of unemployment are borne very unevenly.

There are large distributional consequences. In other
words, the costs of a recession are borne
disproportionately by those individuals who lose their
jobs. For instance , students who graduated during a
recession face difficulty in getting a job.
o Natural Rate of Unemployment

The natural or frictional unemployment occurs at the point of full

employment. The determinants of full employment can be explained in
terms of the duration and frequency of unemployment.

 The duration depends on cyclical factors; the organization of the

labor market, including the presence or absence of employment
agencies; and the ability and desire of the unemployed to keep looking
for a better job, which also depends on the availability of
unemployment benefits. A person may quit a job to have more time to
look for a new and better one. This time of unemployment is known as
Search Unemployment. The higher the unemployment benefits, the
more likely people are to keep searching for a better job, and the more
likely they are to quit their current job to try to find a better one. Thus
an increase in unemployment benefits will increase the natural rate of
unemployment.
 The frequency of unemployment is the average number
of times, per period, that workers become unemployed.
There are two determinants of the frequency of
unemployment. The first is the variability of the demand
for labor across different firms in the economy. Even
when aggregate demand is constant, some firms are
growing and some are contracting. The contracting firms
lose labor, and the growing firms hire more labor. The
second determinant is the rate at which new workers
enter the labor force. The more rapidly new workers
enter the labor force, the faster the growth rate of the
labor force, and the higher the natural rate of
unemployment
o Is a Little Inflation Good for the Economy?
James Tobin argued that a small amount of inflation is
good for the economy-- reduces the natural rate of
unemployment. This is because it provides a necessary
mechanism for lowering real wages without cutting
nominal wages. In a changing world, some real wages need
to go up and some need to go down in order to achieve
economic efficiency and low unemployment. It is easy to
raise real wages by simply raising nominal wages faster
than inflation. To cut real wages, firms must hold nominal
wage increases below the rate of inflation. For e.g., at 10%
inflation rate, a 3% real wage cut can be accomplished by
holding the nominal wage decrease to 7%. But at zero
inflation, firms would have to cut paycheck by 3%.
o How Long are the Unemployed without Work?
To answer this question one has to judge the
seriousness of the problem. One has to consider whether
unemployment is typically a short – term or long – term
condition. If unemployment is short – term, the problem
is not too big. Workers may require a few weeks between
jobs to find the openings that best suit their tastes and
skills. But, if unemployment is long – term, it is a serious
problem.
 Inflationary Gap
Inflationary Gap exists when, at full employment
income level, aggregate demand exceeds aggregate supply.
This means that due to increase in investment and
government spending, the money income increases, but
production does not increase because of the limitations
of productive capacity. As a result, an inflationary gap
comes to exist, causing the prices to rise. The prices
continue to rise so long as inflationary gap exists. The Gap
arises when a government chooses to finance even its
normal expenditure through monetary expansion in a
time of full employment. The important cases of
inflationary gap are associated with the government
expenditure on war or war preparations.
o Demand - Pull and Cost – Push Inflation
 Demand – Pull inflation may be defined as a situation where the
aggregate demand exceeds the economy’s ability to supply the
goods and services at the current prices, so that prices are
pulled upward by the upward shift of demand function
 Cost – Push Inflation, also called sellers’ or mark-up inflation
explains the rise in price when economy is not at full
employment. The prices may be pushed up as a result of rise in
the cost of production. The basis of cost – push theory is that
organized groups, both business and labor fix higher prices for
their products and services. It is characterized by insufficiency
of aggregate demand, unemployment of resources and excess
capacity
 EuroZone
 Over the past week, the European Union's statistical
office has delivered a string of statistics that don't bode
well for consumer spending in the latter part of 2012. A
sharp rise in the region’s unemployment rate, coupled
with the high level of inflation, became the latest evidence
of the damage the single currency bloc’s long-running
fiscal crisis is doing to the real economy, as governments
cut spending to try to control their debts.
 "High and rising unemployment, and relatively
sticky inflation, does not bode well for consumer
spending across the euro zone, especially as
consumers in many countries are also facing
muted wage growth and tighter fiscal policy," said
Howard Archer, Chief European Economist at IHS Global
Insight.
 Unemployment in the 17-country euro zone hit a
record high of 11.6 percent in September, official
figures showed up from an upwardly revised 11.5
percent in August. In total, 18.49 million people
were out of work in the region last month, up
146,000 on the previous month, the biggest increase
in three months
 Five countries in the euro zone are already in recession
Greece, Spain, Italy, Portugal and Cyprus and others are
expected to join them soon. The region as a whole is
expected to be confirmed to be in recession when the
first estimate of euro zone economic activity in the third
quarter is published in mid-November.
 “With unemployment near a record high, banks cutting
back their lending and fiscal austerity set to hit
households soon, the consumer outlook appears bleak,”
said Jennifer McKeown, a senior European economist at
Capital Economics, in a note. “Unfortunately, the situation
seems very unlikely to improve for some time.”
 Wage growth has remained subdued, at about 2
percent, and a slowdown seems very likely. With
inflation hovering around 2.5 percent for the past year,
real disposable incomes have already fallen in three of the
past five quarters, causing the annual growth rate to turn
negative for only the second time on record.
 Separately, the European Commission said confidence
among consumers and businesses in the euro zone
continued to deteriorate in October to the lowest levels
in around three years. This report suggests that the
economy started the fourth quarter on a very weak note.
 “With the further, appreciable rise in unemployment in
September highlighting that the euro zone faces a difficult
fourth quarter and beyond after almost certainly suffering
further GDP contraction in the third quarter, and with
the underlying inflation situation in the euro zone still
looking far from alarming, we believe that the ECB will
ultimately take interest rates down from 0.75
percent to 0.50 percent,” Archer said.
 India’s Unemployment
 India's jobless rate stood at 3.8 per cent during
the last fiscal, with Daman and Diu and Gujarat
topping the list of least unemployed among states
and UTs.
 "Our unemployment level is much better than that of
other countries like US, Spain and South Africa," Director
General of Labour Bureau D S Kolmakar told reporters.
 The latest report for the year 2011-12, released by
Labour Bureau (under Union Ministry of Labour and
Employment) here said Daman and Diu and Gujarat
had unemployment rates of 0.6 per cent and 1 per
cent respectively.
 India’s Inflation
 India's headline inflation likely accelerated to an 11-month
high in October on costlier fuel and food, a headache for
the government in a battle with the central bank over
spending and high interest rates ahead of state elections.

 India's annual consumer price inflation fell in

September to 9.73 per cent, driven by a marginal
fall in fuel and food prices.