Module VII: Inflation and

Unemployment

By Shikha Singh
 Meaning of Inflation
Inflation is a persistent and an appreciable increase in the general level of prices
Inflation leads to a decrease in the purchasing power of money.
A sustained inflation takes place when the general price level continues to rise
over a fairly long time period.
Disinflation is a situation where there occurs a decrease in the rate at which
prices are rising.
Deflation is a situation where there exists a persistent decrease in the general
level of prices.
 Measurement of Inflation

The two ways in which inflation can be measured are through a

1. change in the price index : Price index in period (t) - price index in period (t-1)/price index in period (t)
where t= times period selected for study, t-1= the preceding year
2. Gross national product deflator = Nominal GNP (at current prices)/Real GNP (at constant prices)
As far as the price index is concerned, two indexes are CPI and WPI.
CPI (Consumer Price Index) is a weighted average of prices of goods and services purchased by consumers.
WPI (Wholesale Price Index) is average price of goods which are traded in wholesale market.
The GNP deflator is based on the prices of all the goods.
The Economic and Social Effects of Inflation
 Economic Effects of Inflation

1. On the Distribution of Income :Impact of inflation is felt unevenly by the different

groups of people.
 Gainers from inflation are the producers, those investing in equities and the debtors.
 Losers from inflation are the unorganized workers and agricultural laborers, those
investing in bonds, creditors and the recipients of incomes from rent.
 Inflation leads to a redistribution of income with the rich becoming richer and the
poor becoming poorer.
 Economic Effects of Inflation

• a) Producers including manufacturers, traders and farmers whose income is derived from
profits, gain from inflation. As far as the manufacturers are concerned, they are able to sell
their goods at high prices. No doubt there is an increase in wages, interest rates, rent and
cost of raw materials. However it has been observed that the increase in prices is much
more than increase in the cost of production. Thus profit margin of the producer
increases. Also there is time lag between increase in price and wages increase, which
again is in the interest of the producers.
Big farmers and traders gain during inflation. Demand for agricultural goods is less
elastic and the hoarding of these goods by the traders leads to increase in prices. In
contrast small farmers who have just enough for subsistence , do not gain due to inflation.
 Economic Effects of Inflation

b)Those investing in equities benefit due to inflation. Due to the increase in

price, firms make large profits. The shareholders benefit in two ways: one
though dividends and other due to increase in share price.
c) The debtors gain due to decrease in the value of money which reduces
the burden of interest owed by them.
 Economic Effects of Inflation

• Losers from inflation include the following:

a) Wage and salary earners (who are unorganized and without any wage contracts) lose due to inflation.
Unorganized workers are unable to achieve wage increase since they do not have unions. Even the
agricultural laborers who are unorganized and ignorant are also badly affected by inflation.
b) Bondholders holding fixed interest yielding bonds suffer in two ways: one through decrease in the
real income from bonds and second on account of capital losses if they decide to sell the bonds.
c) The creditors lose due to decrease in the value of money which reduces the real worth of the interest
that they get from their debtors.
d) Recipients of incomes from rent also are hurt during inflation only in case where there are no
escalator clauses, which enable the landlords to protect their interests.
 Economic Effects of Inflation

2. On the Distribution of Wealth

A household’s wealth depends on the difference between the value of its assets and its debts.
Assets include variable price assets and fixed claim assets.
Debt includes housing loans and others which are generally fixed in money terms.
The influence of inflation on an individual’s wealth depends on the division of the assets between fixed
claim assets and variable price assets and the extent of its debts in comparison to its fixed claim assets.
• A household’s gain from physical assets like property, gold, and silver jewelry (variable price
assets)depends on the increase in the price of these assets vis-a-vis inflation.
• Fixed claim assets including bonds, debentures and bank deposits, their real worth decline during inflation.
Thus during inflation people move from away from fixed claim assets to physical assets which leads to
more unproductive savings at the macro level.
 Economic Effects of Inflation

3. On Output and Employment

As far as the short run is concerned, economists are of the opinion that for an
economy which is operating below full employment, inflation of the
creeping or crawling type may prove to be favorable. However a very high
inflation proves to be detrimental to economic growth.
• An unanticipated inflation leads to an improvement in the allocation of
resources and thus to an increase in employment and output.
 Economic Effects of Inflation

4.On the rate of long run economic growth: It has been observed in various countries that there exists a positive
relationship between inflation and economic growth. During inflation, wages lagged behind prices. This resulted in
i. Huge profit margins, which provided not only the incentive but also resources to the firms to invest in capital goods.
The high profits were also responsible for huge savings, given the fact that high income group saves more than the low
income group.
ii. A shift of resources from wage goods to the capital goods.
The result was an increase in the production of capital goods leading to an increase in the productive capacity and hence
the economic growth. In modern times ,the situation seems to be different. As now the workers are more organized
which prevents the wages from lagging behind the prices.
• Thus most economists agree that a moderate inflation is conducive to economic growth as : little inflation greases
the wheels of the labour market and thus lubricates the economy.
It has been observed in various countries that there exists a positive relationship between inflation and economic
growth.
 Social Effects of Inflation

Perfectly anticipated inflation exists when the rate of inflation is steady,

perfectly predictable and expected.
Imperfectly anticipated inflation is that inflation which people do not
expect.
The costs on the society of an imperfectly anticipated inflation include an
arbitrary redistribution of wealth and an unfavorable effect on decision
making.
 Social Effects of inflation

• Inflation has some social effects which result in problems for the society: Two types of inflation in this
regard:
I] Perfectly anticipated inflation: It exists when the rate of inflation is steady and perfectly predictable. Such
inflation imposes certain costs on the society. These are:
a) Menu cost: With high rate of inflation, firms are expected to adjust their announced prices. This involves
making changes in the catalogues and cash registers. Such costs are called menu costs. The higher the
inflation rate the more often the firms have to print the new menus. It has been noticed that more often
firms facing menu costs are not willing to change prices frequently. This may lead to inefficiencies in the
allocation of resources.
 Social Effects of inflation

(b) Shoe leather cost: The cost of holding money by an individual is the interest, which
he forgoes by not holding an asset which could have earned him an interest.
When there is a rise in the rate of inflation, there is an increase in the nominal
interest rate and thus the cost of holding money rises. In such situations people
generally prefer to keep money in banks to earn interest income and then they make
frequent trips to the bank to withdraw smaller amounts of money and leave the rest
to earn interest. The frequent trips to the bank result in wearing out of one’s shoe
more quickly. This is the shoe leather cost of inflation.
 Social Effects of inflation

c)Distortions in taxation : Income tax slabs and tax rates are generally not inflation
linked. They are subject to periodic reviews as part of govt. annual budgetary exercise.
As the tax codes measure nominal income and not real incomes, inflation can influence
the individual’s real tax liability. Thus inflation distorts taxes.
d)Inconvenience in using money as a yardstick: Money is the yardstick which
measures the economic transactions. However, this yardstick itself is affected by
inflation. For eg. When the value of rupee itself keeps changing ,then it is less useful in
the measurement of economic transactions.
 Social Effects of inflation

II]Imperfectly anticipated inflation: It is inflation which people do not expect which

imposes certain costs on the society.
a) Social stability - At very high rates, confidence in the currency is eroded and
production and exchange can be stifled – can lead to food riots, looting and violence
b) Wealth costs – inflation affects those on fixed incomes and redirects wealth to other
(physical) assets since with unexpected inflation realised interest rates are lower than
nominal interest rates.
c)Inequalities: Burden of inflation is disproportionately large on the poor, high inflation
by itself leads to distributional inequality.
 Inflation in India

India is the only major country

that uses a wholesale index to
measure inflation.
The years 2000–2001, 2004–
2005 and 2008–2009 show the
highest average rate of inflation
with 2008–2009 recording the
highest average in the decade.

Table 19.1: Annual WPI Inflation rate (%) (Base: 1993–1994 = 100)
Source: Economic Survey 2008–2009
 Inflation in India

• In 2013, the consumer price index replaced the wholesale price index (WPI) as a main measure of inflation.
• In India, the most important category in the consumer price index is Food and beverages (45.86 percent of total
weight). Housing accounts for 10 percent; Transport and communication for 8.6 percent; Fuel and light for 6.84
percent; Clothing and footwear for 6.5 percent; Medical care for 5.9 percent and education for 4.5 percent.
• Consumer price changes in India can be very volatile due to dependence on energy imports, the uncertain impact
of monsoon rains on its large farm sector, difficulties transporting food items to market because of its poor roads
and infrastructure and high fiscal deficit.
• Consumer prices in India increased 5.18 percent year-on-year in February of 2016, lower than 5.69 percent
in January and below market expectations of 5.6 percent. Consumer inflation eased for the first time in seven
months, reaching the lowest since October due a slowdown in food cost. Inflation Rate in India averaged 7.85
percent from 2012 until 2016, reaching an all time high of 11.16 percent in November of 2013 and a record low
of 3.69 percent in July of 2015.
 Inflation in India
• The forecast for - India Inflation Rate - was last predicted on Tuesday,
March 29,2016.
Forecast Actual Q1/16 Q2/16 Q3/16 Q4/16 2020
Inflation
5.18 5.6 5.4 4.9 5.1 4.8 percent
Rate
http://www.tradingeconomics.com/india/inflation-cpi
Inflation in India
 Keynesian Approach to Inflation

Keynes had argued that inflation occurs due to an increase in

the aggregate demand.
The inflationary gap (shown as AB) is the amount by which
the aggregate demand exceeds the aggregate output at the full
employment level.
An economy can come out of an inflationary gap through
appropriate policy measures, like increasing taxes or reducing
government expenditure.
Keynes’ theory of inflation is a non-monetary theory as the
increase in the money supply do not play any role in the
theory.
Figure 20.1 depicts an inflationary gap.
 Modern Approach to Inflation

According to the modern approach, changes in the price level can be

related to changes in aggregate demand and the aggregate supply.
When the increase in the price level is due to an increase in the
aggregate demand, it is called demand pull inflation.
 When the increase in the price level is due to an increase in the
aggregate supply, it is called cost push inflation.
Monetarists are of the view that changes in price level can be
explained mainly in terms of the changes in the supply of money.
Inflation is always and everywhere a monetary phenomenon.
 Inflation: Demand Side (Demand Pull Inflation)

An excess demand leads to demand pull inflation since the inflation
occurs as the aggregate demand is pulled above what the economy’s
potential output is in the short run.
Demand pull inflation occurs due to a change in the real factors.
A change in the real factors leads to a rightward shift of the IS curve
as in Figure.
Assumptions:
1. AS curve slopes upward to right and then becomes perfectly
inelastic at full employment level of output.
2. Economy is operating at full employment. Thus, rightward shift in
AD curve only influences the price level.
 Inflation: Demand Side (Demand Pull Inflation)

 The intersection of IS1 and LM curves determines the initial equilibrium at point E1,with rate
of interest at r1 and income level at Y1.,which represents full employment real output. The AD
curve which corresponds to the IS1 and LM curve is given by AD1. The curve AD1 and AS
intersect to determine the equilibrium at E1 with income level at Y1 and price level at P1.
 Curve AS represents the aggregate supply which rises upward in the beginning but when full-
employment level of aggregate supply OY1 is reached, aggregate supply curve AS takes a
vertical shape. This is because after the level of full employment, supply of output cannot be
increased.
 An increase in investment shifts the IS curve to the right to IS2.It meets LM curve at E2,with
interest rate at r2 and income level at Y2. The AD curve which corresponds to LM and IS2 is
AD2.It determines the price level at P2. The increase in price from P1 to P2 is required to
eliminate the excess demand =Y2Y1 that exists at price P1. This excess demand is the result of
rightward shift of the IS curve. The increase in price to P2 eliminates the excess demand to re-
establish the equilibrium at full employment income Y1 and price level at P2
 Demand Pull Inflation: Real factors
•A change in real factors include:

An increase in exports
An increase in government expenditure
with no change in tax revenue A decrease in imports

A decrease in government tax revenue with Growing Population
no change in government
Very fast growth of demand for credit/
expenditure/Reduction in taxes – more borrowing
disposable income
An increase in investment
High level of consumer spending
A decrease in savings Rising consumer confidence, increase in
the rate of growth of property prices ,
Black Money stock prices
 Demand Pull inflation: Monetary factors
• A change in monetary factors includes:
• An increase in the money supply • A decrease in the demand for
• Bank credit money
• Deficit financing
• Government Expenditure
• FII inflows
• Central bank Intervention to
manage Rupee fluctuations
 Demand Pull Inflation Arising from Monetary Factors

Demand pull inflation also occurs due to a change in the monetary factors. A
change in the monetary factors leads to a rightward shift of the LM curve.
The intersection of IS and LM1 curve determines the equilibrium at point E1
with rate of interest at r1 and income level at Y1.The AD curve corresponding to
the IS and LM1 is given by AD1. Ad1 meets AS at E1 with income level at Y1
and price level at P1.
Increase in money supply shifts the LM curve to right –LM2 which meets the IS
curve at point E2 with interest rate at r2 and income level at Y2.
The Ad2 curve corresponds to the IS and LM2 and intersects with the AS curve
to determine the price level at P2. Once again, the increase in price level from P1
to P2 is required to eliminate the excess demand equal to Y2Y1that exists at
price level 1.This excess demand is the result of rightward shift of the LM curve.
 Concluding remarks
• While Friedman is of the view that inflation is caused by monetary
factors, Hicks is of the opinion that money plays only a supportive role as
far as inflation is concerned. Thus, economists differ in their opinion as to
the role performed by the real and monetary factors in the modern demand
pull inflation.
 Cost Push inflation
The theories of cost push, also called mark up or seller’s inflation came in the 1950s.
• They appeared to refute the demand pull theories of inflation. These theories lay emphasis on an autonomous
increase in some component of cost as the source of inflation and which leads to an upward shift in the supply
curve. 3 ingredients common to these theories are:
1. The upward push in costs is independent of the demand conditions prevailing in the relevant market
2. The push forces work through some important component of costs like wage and profits
3. The increase in costs is not absorbed by the firms , which are producing goods but are passed on the consumers
of goods.
There are three main kinds of cost push inflation:
For a wage push inflation to occur, it is not necessary that the labour market is completely unionized.
For a profit push inflation to occur, the existence of imperfect competition in the sale of goods is a necessary
condition.
Supply-shock inflation is caused by occurrences like the increase in the prices by the OPEC and even crop failures.
 Diagram – Cost Push inflation

• Lets assume that marginal productivity of the labour is decreasing and

the cost push inflation arises from an autonomous increase in the wage E3
rate. E2
• The AD & AS1 curves intersect to determine initial equilibrium at point E1
E1 with income level Y1 and price level P1 at a particular wage rate.
• Now suppose there is an increase in wage rate, which is entirely due to
the monopoly power of the labor unions and is in no way linked to the
increase in labour productivity or demand for more labour.
• This will shift AS1 curve to AS2 ,if there is further increase in wage rate.
As the supply curve shifts leftwards, price increases, output and
employment declines.
 Wage push inflation

• This is caused by an increase in the money wage rate, which is in excess of the increase in the
labour productivity. The reason behind this increase in the money wage may be the monopoly
power of the trade union in the imperfectly labour markets, which may pressurize the
employers for a wage increase.
• As this increase does not match to an increase in the labour productivity, it will lead to an
increase in the cost of production and thus to an upward shift in the supply curve. This will
further lead to an increase in the price level.
• To note that wage inflation cannot occur in an economy where the labour markets are
competitive. In such a market, the money wage rate will increase or decrease only in response
to variation in the demand or supply for labour.
 Wage push inflation

• For a wage push inflation to occur, it is not necessary that the labour market is completely unionized. It
is sufficient that a small segment is unionized because then the effect of a wage push in the unionized
industries may spread to the non-unionized industries. This is because the non-union wages are closely
linked to union wages.
• It is not necessary that every increase in the money wage rate leads to a wage push inflation. An
increase in the money wage rate does not lead to a wage push under certain conditions:
1. When the increase in the money wage rate is matched by an increase in the labor productivity
2.When the increase in the money wage rate results from an excess demand for labor, derived from an
upward shift in the aggregate demand for goods and not due to the monopoly power of the labor union.
 Profit push inflation

• This is caused by the exercise of the monopoly power of the oligopolistic and
monopolistic industries to enhance their profit margin. Thus, the monopolists and
oligopolists may often go for a price rise which is more than any increase in the
costs.
• For a profit push inflation to occur the existence of imperfect competition is a
necessary condition.
• The process is the same as that described in the diagram for wage push inflation.
The AS curve shifts resulting in profit push inflation.
 Supply shock inflation

• This is caused by occurrences like the increase in the prices by the OPEC and even crop
failures.
• It is important to note that supply shocks are unanticipated and unexpected.
• The process here is the same in reference with diagram, AS curve shifting upwards.
• Unlike monopolists, oligopolists, and the labor unions which are under the control of the
authorities, OPEC is a foreign organization which is outside the control of any authorities.
• Similarly, crop failures and shortages are again subject to vagaries of nature and thus
beyond the control of any govt.
 Cost Push inflation - causes

• External shocks ( commodity prices fluctuations)

• Depreciation in exchange rate
• Acceleration in wages
• Rise in Administered Prices
• Import Prices of Essential Commodities
• Inadequate Agricultural Production
 Relationship Between Demand Side Inflation
and Supply Side Inflation

Some economists are of the view that any inflationary process contains some
aspects of both demand side and supply side inflation. 2 situations are possible:
1. An inflationary process may begin with an excess demand and may continue as
long as the excess demand persists.(depicted in fig. by the shifts in AD curve from
AD1 to AD3.AS1 curve remaining unchanged. Cost push factors are not playing any
role whatsoever in the inflation process. The equilibrium shifts from E to A to C,
while the output remains unchanged at Y1,prices will increase from p1 to p4and so
on. (In extreme cases it might be a situation of hyperinflation.)
It is quite possible that in the situation of full employment and inc. in AD the wage
rates may increase. The increase in money wage rate shifts the AS1 to AS2at point
A. However it is quite possible that increase in price leads to a situation where
producers find their profits lower. Thus they increase the administered prices. This
situation creates a wage price spiral where the general price level and money wage
rates follow each other in a upward spiral.
 Relationship Between Demand Side Inflation
and Supply Side Inflation

2. An inflationary process may begin on the supply side but it will

not continue unless there is an excess demand. In the figure it is
depicted by a shift in the As curve form As1 to As3. Agg. demand
remaining unchanged at Ad1.Demand pull factors are not playing
a role in this inflation process. As a result equilibrium shifts to
point E to F to G. While the output (and thus employment) will
decrease from Y1 to Y2 to Y3 and prices increase from p1 to p2
to p3 and so on.
The successive decreases in the output level and the growing
unemployment levels will ultimately put an end to inflation
process.
The increase in the money wage rate leads to an increase in the
prices. However this inc in d price will not be sustained unless it
is followed by appropriate changes in AD
 Control of Inflation

 Inflation due to Monetary Expansion (Monetary inflation)

 Inflation due to rise in real aggregate demand (Real
inflation)
 Inflation due supply side: cost push inflation
 Control of inflation – Demand Pull inflation

If the inflation is due to demand side factors, restrictive monetary

and fiscal polices are commonly used to control inflation. Any
increase in government expenditure, investment shifts aggregate
demand leading to an increase in price level, can be counteracted by
restrictive monetary and fiscal policies. This is because such policies
have an immediate impact on the level of aggregate demand.
 Control of inflation :Supply side
• In case of supply side inflation, restrictive monetary and fiscal policies are not
appropriate for controlling inflation. This is because supply side inflation is
accompanied by rising prices and an output below the full employment level.
• The intersection of AS1 and AD2 at point E depicts full employment output at
Y1 and price level at P1. Assume an increase in the money wage rate shifts the
AS curve to AS2.The intersection of AD2 and AS2 at point F depicts the
decrease in output to Y2 and the price level at P2.
• An attempt at using restrictive monetary and fiscal polices to prevent the price
rise will lead to a shift of the aggregate demand curve AD 1.
• The intersection of AS2 and AD1 at point G depicts a further decrease in the
output while the price level remains unchanged at P 1.
• Hence it is apparent that an attempt at controlling a supply side inflation
through such policies can be achieved only at the cost of reduction in the
output and employment level. Such an increase in the unemployment may not
be socially acceptable and may in fact result in an economic slowdown.
 Unemployment and Related Terms
In the real world full employment is just not possible. All economies experience some unemployment accompanied by low standards
of living, hardships, psychological distress and mental agony. Side by side unemployment in most countries are also plagued with
inflation and its related consequences. Hence we need to understand the relationship between the rate of inflation and unemployment.
The labor force consists of both the employed as well as the unemployed.
The unemployment pool is formed by the unemployed persons at any point of time. As more and more people enter the pool,
unemployment increases.
The duration of unemployment indicates whether unemployment is short term or long term.
The unemployment rate =
labor force - no. of people employed/ labor force X 100
E= total no of employed persons
U= total no of unemployed persons
L= total labour force
L= E+U
Therefore, rate of unemployment = U/L
 Unemployment Rate in India
• Unemployment Rate in India decreased to 4.90 percent in 2013-14, mainly on account
of an increase in joblessness in rural areas despite the government's flagship
employment scheme MGNREGA.
• It was 5.20 percent in 2012.
• Unemployment Rate in India averaged 7.32 percent from 1983 until 2013, reaching
an all time high of 9.40 percent in 2009 and a record low of 4.90 percent in 2013.
• Unemployment Rate in India is reported by the Ministry of Labour and Employment,
India.
 Unemployment Rate in India :Census report

• Ten million Indians with graduate, post-graduate and technical degrees were looking for
work, meaning that 15% of all Indians with the highest levels of education were seeking
job as of 2011. Kerala had India’s highest graduate unemployment rate at over 30 per
cent.
• The data emerges from new Census 2011 numbers analysed by The Hindu. Of the
116 million Indians who were either seeking or available for work, 32 million were
illiterate and 84 literate. Among literates, unemployment rates were higher among the
better qualified, highest of all among the 7.2 million people with a technical diploma or
certificate other than a degree. At all levels of education, unemployment rates were
higher in rural than in urban areas. At every level of education, especially at the higher
levels, female unemployment exceeded male unemployment. The ‘unemployed’
included those who were not currently working but were seeking or available for work,
as well as those in marginal employment — meaning that they worked for fewer than
six months in the year preceding the Census — who were seeking or available for work.
Overall, India’s unemployment rate grew from 6.8 p.c. in 2001 to 9.6 p.c. in 2011, based
on official Census data. Unemployment grew faster for illiterates than for literates. In
all, India had just 56 million graduates and post-graduates in 2011 and 12 million with a
technical certificate or diploma equivalent to a graduate or post-graduate degree. Half of
these with the highest level of education were classified as “main workers”, meaning
that they worked for at least six months in the year preceding the Census.
 Types of Unemployment
Natural Rate of Unemployment
The natural rate of unemployment is the average rate of•
unemployment around which any economy fluctuates in
the long run.
Policies aimed at reducing the natural unemployment:
1. Unemployment benefits should be reduced as they
allow for longer time period for searching for jobs. These
benefits also reduce the urgency for an unemployed
person to take up a job.
2. A reduction in minimum wages and
3. Giving incentives to workers to take up technical
training.
Eg. Akhilesh Yadav's unemployment allowance scheme
spurs a "jobless mayhem' in Uttar Pradesh, Lucknow, March
2012 :In its poll manifesto, the ruling Samajwadi Party (SP) had
pledged to put unemployed graduates aged between 35 and 40
on the dole. Soon after taking over the reins on March 15, Chief
Minister Akhilesh Yadav decided to implement the scheme
entitling the targeted jobless segment to Rs 1,000 every month.
While about 1.50 lakh youth had registered themselves with the
state's employment offices in the last four decades, the number
shot up to nearly 18 lakh on March 15th in anticipation of the
SP delivering on its promise. The figure further swelled to 25
lakh over the next three days as jobless graduates made a
beeline for various district employment offices in the state. )
 Frictional Unemployment
Frictional unemployment arises due to the time gap it takes for the workers to search for a job that best
suits their individual skills and tastes when the economy is at full-employment.
As neither are the workers identical nor are all the jobs identical, it becomes difficult to match the
worker’s skills, preferences and their abilities with the job profile. Hence every economy has some
amount of frictional unemployment. If it is reduced then natural rate of unemployment will also fall.
Causes of frictional unemployment: 1. Sectoral shift (sectoral shift is actually a change in the
composition of demand among industries. This occurs due to advancement of technology and new
inventions. ) 2. Failure of a firm and thus laying off workers,
3. Worker’s performance may not be satisfactory and thus he is unexpectedly out of work.
4. A particular skill in which a worker has expertise may no longer be needed.
 Relationship Between Inflation and Unemployment
Phillips Curve

Named after the British economist A.W. Phillips who, in the year 1958 presented a
study which was based on the behavior of wages and their relationship to
unemployment, in the United Kingdom for the time period 1861 to 1957.
The Phillips curve shows that there exists an inverse relationship or trade-off
between the rate of unemployment and the rate of increase in money wages or
wage inflation. The higher the rate of unemployment, lower is the rate of wage
inflation.
Gw= W-W-1/W-1
where, Gw is = rate of wage inflation, W=wage in the current period, W -1 =wage in the preceding year.

In the fig. the original Phillips curve has been depicted showing an inverse relationship
between the rate of unemployment and wage inflation.
 Relationship Between Inflation and Unemployment
Phillips Curve

• The natural rate of unemployment is the amount of frictional unemployment that exists at the level
of full employment. We denote it by U* The Philips curve can be presented as :
Gw = -e (U-U*),
Where, e = it measures the responsiveness of wages to unemployment
U = the unemployment rate U* = the natural rate of unemployment U-U*= the unemployment gap

• If the U>U*, it implies that unemployment rate is greater than the natural rate and , hence the wages
fall
• If the U< U*, it implies that unemployment rate is lower than the natural rate, hence the wages rise.
 Philips curve relationship: An
explanation
• Behavior of the organized labor: Wage push factor: wage push inflation is caused by an
autonomous demand by the labor unions for increase in wages which are in excess of increase in
labor productivity. This leads to an increase in prices of goods, resulting in wage push inflation.
• The extent to which labor market can push through these increases in wages will vary inversely
with the unemployment rate in the labour market:
1. During situations of low unemployment rates and tight labour markets, there is buoyant(cheerful)
demand for goods and firms are making profits. Under such conditions, an aggressive labour can
demand higher wages and employers often accede(agree) to these demands.
2. Alternatively, during situations of high unemployment rates and low profits, the employers resist
to even moderate increases in the wages. These relationships produce a Phillips curve.
 Philips curve relationship: An explanation

• An Excess Demand for labour. The fig (a) depicts the equilibrium in the labour
market. OW*= equilibrium wage rate,OW1 = wage rate at which there is an excess
demand for labour equal to EF. OW2 = wage rate at which there is an excess
demand for labour equal to GH.
• So it is obvious that wages are OW1 and excess demand for labour is EF, the
increase in wages will be much greater than with the wage rate OW2 where the
excess demand is only GH.
• This approach can also be expressed in terms of another argument put forward in
terms of Philips curve . The amount of unemployment is inversely related to the
amount of excess demand of labour.
• In the figure (b) OU1 is the unemployment rate at the equilibrium wage rate of
OW* where DDl=SSl.,at this level of unemployment wage rate increase will be
=0. At a wage rate lower than OW*,there will be excess of labour or low rate of
unemployment and thus greater increase in wage rate. This will imply a movement
up the Philips curve.
•
 Phillips curve: Policy implications
• According to Phillips curve there exists a trade off between inflation and unemployment. In other word a lower
unemployment rate can be achieved only at a higher rate of inflation.
• Every economic policy aims at achieving two goals – low inflation (price stability) and low unemployment
(economic growth). These objectives however are conflicting.
• According to Philips curve, policy makers could make a choice between different combinations of rate of inflation
and unemployment. They could have low inflation but at the cost of high rate of unemployment or vice versa. Hence
its a dilemma for the policy makers.
• The dilemma arises because it has been found that controlling or ignoring inflation both have undesirable effects on
the economy. therefore the question ‘whether inflation should be controlled and if yes, to what extent’.
• Empirical evidence shows that trade-off exists only in the short run. In the long run, Phillips curve is vertical
implying that unemployment is independent of inflation rate.
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