Aggregate Supply and the Phillips

Curve
Session 13 to 15
 Introduction
• Further develop the AS side of the economy; examine the dynamic
adjustment process from the short run to the long run
– The price-output relationship is based upon links between wages, prices,
employment, and output
 link between unemployment and inflation = Phillips Curve
– Translate between unemployment and output, inflation and price changes

• NOTE: theory of AS is the least settled area in macro

– Don’t fully understand why W and P are slow to adjust, but offer several
theories
– All modern models differ in starting point, but reach the same conclusion:
SRAS is flat, LRAS is vertical
 Recession and Unemployment
• Recession: Technically defined as two consecutive quarters of negative GDP
growth rate (shaded area)
• U.S. unemployment over several decades
– Several periods of high unemployment: early 1960s, mid 1970’s, early-mid 1980’s, early
1990s, late 2000s, and the current period
– Several periods of low unemployment: late 1960’s, early 2000, and 2007
 The Phillips Curve
• In 1958 A.W. Phillips
published a study of
wage behavior in the
U.K. between 1861 and
1957
• The main findings are
summarized in Figure
® There is an inverse
relationship between
the rate of
unemployment and
the rate of increase in
money wages
® From a policymaker’s
perspective, there is a
tradeoff between
wage inflation and
unemployment
 The Phillips Curve
• The PC shows the rate of growth of wage inflation decreases with increases in
unemployment
– If Wt = wage this period
Wt 1  Wt
Wt+1 = wage next period gw 
gw = rate of wage inflation, then Wt

• If * represents the natural rate of unemployment, the simple PC is defined as:

∗
𝑔𝑤 =−𝜀 (𝜇 − 𝜇 )
 

• where  measures the responsiveness of wages to unemployment

– Wages are falling when  > * and rising when  < *
– ( - *) is called the unemployment gap
For wages to rise above
previous levels, u must fall
𝑊 • −
𝑡+1 𝑊
Take the
𝑡 two sides together ∗
=− 𝜀 (𝜇 − 𝜇 ) below the natural rate
𝑊𝑡
∗
 𝑊 𝑡 +1 − 𝑊 𝑡 = 𝑊 𝑡 (− 𝜀 ( 𝜇 − 𝜇 )) Higher wages translates into
∗ cost and price rise in the
 𝑊 𝑡 +1 =𝑊 𝑡 [1 − 𝜀 ( 𝜇 − 𝜇 )]
medium-run
 The Policy Tradeoff
• PC quickly became a
cornerstone of
macroeconomic policy
analysis since it suggests
that policy makers could
choose different
combinations of u and
 rates
– Can choose low u if
willing to accept high 
(late 1960’s)
– Can maintain low  by
having high u (early
1960’s)
• In reality the tradeoff
between u and  is a
short/medium run
phenomenon
 = inflation rate
– Tradeoff disappears as
AS becomes vertical
Phillips curve (PC) shows the relationship between
unemployment and inflation
 Story Does not Remains the Same
• The behavior of  and u in the
US since 1960  does not fit
the simple PC story
– Individuals are concerned
with standard of living, and
compare wage growth to
inflation
– If wages do not “keep up” with
inflation, standard of living falls
– Individuals form
expectations as to what 
will be over a particular
period of time, and use in
wage negotiations (e)
• Rewrite the PC to reflect this
as:
𝑔  𝑤 =Π 𝑒 − 𝜀 ( 𝜇 − 𝜇∗ )
 The Inflation Expectations-Augmented
Phillips Curve
• If maintaining the assumption of a constant real wage, W/P, actual  will equal
wage inflation (rise in W should match the rise in P)
• The equation for the modern version of the PC, the expectations augmented PC, is:

 Π = Π 𝑒 − 𝜀 ( 𝜇 − 𝜇∗ )

NOTE:
1. e is passed one for one into actual 
2. u = u* when e = 
 The Inflation Expectations-Augmented
Phillips Curve
• The modern PC
intersects the natural
rate of u at the level of
expected inflation

• Figure illustrates the

inflation expectations-
augmented Phillips
curve for the 1980s and
early 2000

• The height of the SRPC

depends upon e

• At u* the inflation
equals e
 The Inflation Expectations-Augmented
• Changes in expectations Phillips Curve
shifts the curve up and
down
– The role of e adds another
automatic adjustment
mechanism to the AS side
of the economy
• When high AD moves the
economy up and to the left
along the SRPC,  results
– if persists, people adjust
their expectations
upwards, and move to
higher SRPC
 The Inflation Expectations-Augmented
Phillips Curve
• After 1960, the original PC
relationship broke down
• How does the augmented PC
hold up?
= Π 𝑒 − 𝜀 ( 𝜇 − 𝜇∗ )
• To test the augmented PC,
need a measure of e  best
estimate is last period’s
inflation, e = t-1
• Figure illustrates the
augmented PC using the
equation:
   e     t 1   (u  u* )
 Appears to work well in most
periods

Note the vertical axis: It is like acceleration

 Rational Expectations
• The augmented PC predicts that actual  will rise above e when u < u*
• So why don’t individuals quickly adjust their expectations to match the
model’s prediction?
– The PC relationship relies on people being WRONG about  in a very
predictable way
– If people learn to use the equation to predict , e should always equal ,
and thus
 Π u ==u * Π 𝑒 − 𝜀 ( 𝜇 − 𝜇∗ )

• Robert Lucas modified the model to allow for mistakes

– He argued that a good economics model should not rely on the public making
easily avoidable mistakes
– So long as we are making predictions based on information available to the
public, then the values we use for e should be the same as the values the
model predicts for 
– Surprise shifts in AD will change u, but predictable shifts will not
• Presume that RBI expands money supply by 10 %
each year, and wages are raised by 10% each year
• How will AS-AD move overtime

• RBI governor goes on holiday for a year without

others knowing this (or RBI decides not to raise
money supply, but did not publicize this)
• How would this affect AS-AD model
• Presume that RBI expands money supply by 10 %
each year targeting 4 percent inflation and
expecting 6 percent real growth, and wages are
raised by 4% each year
• How will AS-AD move overtime

• Unfortunately, the growth turns out to be zero

percent only for the year.
• How would this affect AS-AD model
 Rational Expectations
• The argument over rational expectations is as follows:
– The usual macroeconomic model takes the height of the PC as being pegged
in the SR by e, where e is set by historical experience
– The rational expectations model has the SRPC floating up and down in
response to available information about the near future
• Individuals use new information to update their expectations

• Both models agree that if money growth were permanently increased,

the PC would shift up in the LR, and  would increase with no LR change
in u
– The RE model states that this change is instantaneous, while the traditional
model argues that the shift is gradual
 AD Policy & the Long-Run
• Central bank increases Supply Curve
money supply
• The AD shifts outward
• The shift of AD leads to
price rise (inflation) and
u<u*. P
t =∞
 
Long-run AS

• Consequently, workers to
revise their inflation
expectations
E’’
• In the long-run the output
reverts back to Y* with Price
higher prices
Short-run AS
• Under rational expectation E’ t0
model, this should have
happened instantaneously

AD AD’

Y* Y
 The Wage-Unemployment Relationship and
Sticky Wages
• In neoclassical theory of supply, wages adjust instantly to ensure that
output always at the full employment level, BUT output is not always at
the full employment level, and the PC suggests that wages adjust slowly
in response to changes in u

• The key question in the theory of AS is “Why does the nominal wage
adjust slowly to shifts in demand?” OR “Why are wages sticky?”
• Wages are sticky when wages move slowly over time, rather than being
flexible, allowing for economy to deviate from the full employment level
 Many Reasons: Why don’t rational expectations
explain how the world operates?
• Each school of thought has to explain why there is a PC, or the reasons for wage
and price stickiness

• Some prices simply can’t be adjusted quickly: ‘Sticky prices’

– labor contracts often set wages for 3 years in advance
– Many loans/deposits are linked to fixed rate

• Agents learn slowly: misperception/imperfect information model

– A producer knows more about the price of own product than other goods
– Need to distinguish whether the rise in price of his product is due to genuine
demand rise (microeconomic) or the general rise in prices
– When nominal wages rises, worker may believe that their real wages have
gone up, thus willing to work more. It takes time to calculate their real wages

• Menu costs
– benefit of setting prices exactly right < the cost of making price changes.
 The Wage-Unemployment Relationship and Sticky Wages
• Coordination failures
– If nominal money supply is raised by the central bank, the AD shifts
outward.
– Despite higher demand, the firm raising prices first might suffer, if others
do not follow

• Insider-outsider model
– Those in the jobs are the one who negotiate with the employer, not the
unemployed fellows
– Unemployed would prefer firms to cut wages and create more jobs, firms effectively
negotiate with the workers who have jobs
– Costly for firms to turn over their labor force—firing costs, hiring costs, training
costs

• Efficiency wages and costs of price changes

– Focus on wage as a means of motivating labor
– Paying higher wages than the market wages, addresses principal agent
 The Wage-Unemployment Relationship and
Sticky Wages
• To clarify the assumptions about wage stickiness, let’s link the relationship
between gw and the level of employment:

If N* = full employment level of employment

N = actual level of employment
u = share of N* that is not employed, then
N*  N
  *

N*
• Substitute this in Philips Curve and we have the PC relationship between
E, e, and gw:

Wt 1  Wt  N*  N 
gw   
e
    
e
*

Wt  N 
 The Wage-Unemployment Relationship and
Sticky Wages
Wt 1  Wt  N*  N 
gw   
e
    
e
*

Wt  N 

• The wage next period is equal to the wage that prevailed this period, but
with an adjustment for the level of employment and e
– At full employment, N* = N, this period’s wage equals last period’s, plus an
adjustment for e
– If N > N*, the wage next period increases above this period’s by more than e
since gw - e > 0

  𝑁 −𝑁∗
𝑊 𝑡 +1=𝑊 𝑡 (1+ Π + 𝜀
𝑒

𝑁 ∗
)
( )
The Wage-Unemployment Relationship and
Sticky Wages
• Figure illustrates the wage-employment relationship, WN
• The extent to which the wage responds to E depends on the parameter 
• If  is large, u has large effects on wages and the WN line is steep

∗
  𝑁 −𝑁
𝑊 𝑡 +1=𝑊 𝑡 (1+ Π + 𝜀
𝑒

𝑁∗ (
 The Wage-Unemployment Relationship and
Sticky Wages
•
• The
•
PC relationship also implies WN relationship shifts over time
 If there is is positive, WN shifts up to WN’ for the next year
• If is negative, WN curve shifts down to WN’’ for the next year
 Result: Changes in AD that alter the u this period will have effects on wages in subsequent
periods

 What is the value of

 The Wage-Unemployment Relationship and
Sticky Wages
• Explanation of wage stickiness has one central element  the labor
market involves long-term relationships between firms and workers
– Working conditions, including the wage, are renegotiated periodically, but not
frequently, due to the costs of doing so

• At any time, firms and workers agree on a wage schedule to be paid to

currently employed workers
– If demand for labor increases and firms increase hours of work, in the SR
wages rise along the WN curve
– With demand up, workers press for increased wages, but takes time to
renegotiate all wages (staggered wage-setting dates)
– During the adjustment process, firms are also resetting P to cover increased
cost of production
• Process of W and P adjustment continues until economy back at full employment
level of output
 Upward Sloping
Short/Medium Run AS
The combination of wages that
are preset for a period of
time and wage P
t =∞
 
Long-run AS

adjustments that are

staggered generates the
gradual wage, price, and
output adjustment we E’’
observe in the real world.
Price
This accounts for the gradual
Short-run AS
vertical movement of the E’ t0
short-run aggregate
supply curve.

AD AD’

Y* Y
 From the Phillips Curve to the AS Curve
The transition from the PC to
the AS curve requires four
steps:
1. Translate output to
employment
2. Link prices firms charge to
costs
3. Use Phillips curve
relationship between
Wages and Employment
4. Combine 1-3 to derive
upward sloping AS curve
Translate output to employment
• Close relationship between
unemployment/employment
and output in SR
• Okun’s Law defines this
relationship:
Y Y*
*
  ( u  u *
)
Y
• Estimate  to be close to 2 
each point of u costs 2%
points of GDP
From the Phillips Curve to the AS Curve

The transition from the PC to Link prices to costs

the AS curve requires four • Firms supply output at a price
steps: that at least covers costs of
production
1. Translate output to
employment
2. Link prices firms charge to • If each unit of N (labour)
costs produces ‘a’ units of output,
the labor costs of production
3. Use Phillips curve
per unit is W/a
relationship between W
and E
• Firms set price as a markup, z,
4. Combine 1-3 to derive
on labor costs to cover all
upward sloping AS curve
other costs excluding labour:
(1  z )W
P
a
 From the Phillips Curve to the AS Curve
∗
• Okun’s law 𝑌
  −𝑌 ∗
∗
=−𝜔 (𝑢 −𝑢 )
𝑌
(1  z )W
• Price and wage link P
a

• Wage equation from Phillips curve

  𝑊 𝑡 +1 =𝑊 𝑡 ¿
• Aggregate Supply
 
𝑃 𝑡 +1= 𝑃 𝑡 ¿
 Y Y* 
Pt 1  P  Pt 
e
t 1 
 Y *

𝑃  𝑡 +1=𝑃𝑒𝑡 +1 [ 1+𝜆(𝑌 −𝑌 ∗ ) ]
This is the equation for the aggregate supply curve
 From the Phillips Curve to the AS Curve
 
 
Pt 1  Pt e1 1   (Y  Y * )
• Figure shows AS curve
implied by equation
• If the initial i.e.

• If Y > Y*, next period the AS

curve will shift up to AS’ due
to rise in
• If Y < Y*, next period AS will
shift down to AS’’ due to
decline in 𝑃 𝑒
𝑡 +1

Thus, expected inflation will

continue to shift the AS
Aggregate Supply curve under conditions in which
wages are less than fully flexible.
 Inflation Inertia
•• The height of the Phillips Curve is . Thus, when the economy
 
remains at full employment, then the inflation rate is , and supply
𝑒
curve continues to shift upward as   𝑃 𝑡 +1 > 𝑃 𝑡

• Full employment is also termed as nonaccelerating inflation rate of

unemployment or NAIRU

• “Why is our money ever less valuable? Perhaps it is simply that we

have inflation because we expect inflation, and we expect inflation
because we’ve had it.”
Robert Solow
 Anticipated vs Unanticipated Inflation
• Anticipated inflation
– Given the past history people do expect to have inflation,
and ask their employer to given pay rise based on that.
Producers also takes it in account while pricing and making
long term contracts.
– Inflation is also important when loans or deposits are made

• Unanticipated inflation
– Actual inflation may turned to be different than the expected
inflation. All the contracts signed based on expectations can
have implications of redistribution of wealth.
 The Costs of Perfectly anticipated inflation
• Suppose an economy has been experiencing inflation of 5% and
the anticipated rate of inflation is also 5%, then all contracts will
build in the expected 5% inflation
– Nominal interest rates account for the inflation (To get 3% real
interest rate, You ask for nominal interest rate of 3% + 5% = 8%)
– Long term labor contracts account for the inflation

® Inflation has no real costs, except for two qualifications

The Costs of Perfectly anticipated inflation

• The costs of holding currency rise along

with the rate of inflation, and the demand
for currency decreases
• The inconvenience of reducing money holding
is metaphorically called the shoe-leather cost of
inflation, because walking to the bank more
often induces one’s shoes to wear out more
quickly.

• When changes in inflation require printing

and distributing new pricing information,
then, these costs are called menu costs.

• These are drain on real resources

 The Costs of Imperfectly anticipated inflation
• Most contracts are written in nominal terms

• Forced redistribution
– Long term lenders charged nominal interest rate as 3% over and above expected
inflation (5%), incidentally the actual inflation rate turned out be 15%. If inflation is
unexpectedly high, debtors repay loans in cheaper currency.
– There was a forced redistribution from lender to borrower.
– Life becomes a lottery or game in which many of are forced to participate against
our wishes

• Allocative efficiency
– Relative prices also becomes unstable leading to distortions in allocative efficiency
– The firms need to differentiate between the ‘pure’ microeconomic rightward shift of
demand induced price rise vs ‘pure’ inflation induced price rise
– The possibility of unexpected inflation introduces an element of risk, which might
prevent some from making some exchanges they otherwise would undertake
 Negative inflation rates (Deflation)
• Like inflation, deflation can also lead to forced redistribution
– Great depression and Burma in 1930s

• Nominal interest rate has to be zero or more than that. This effectively
raises the real interest rate, creating disincentives for investments.
– Monetary policy becomes an ineffective tool since it’s not possible to reduce
the interest rate in case of recession.
– Fiscal policy becomes the only tool to raise aggregate demand

• Given the wage rigidity, firms would find it difficult to reduce real wages
when a particular sector/industry is facing troubles

• The best policy is to stay away from deflation.

– Have 2-3% inflation which helps in proper functioning of the labor markets.
• Initial response to the great depression was a pro-cyclical
policy where the government raised tax-rates and curtailed
expenditure during recession to contain fiscal deficit

Economic Survey, 2021

Business Cycle under Various Fiscal Policy
Stance

Higher Fiscal Multipliers

During Economic Slowdown

Economic Survey, 2021

United Kingdom (1987 – 2019)
Source: UK
Economic Accounts
(ONS) & OBR (UK)
Public Sector net
Balance = Net
lending by General
Govt and Public
Corporations
Private Sector Net
Balance = Net
lending by
Households,
Non Profit
Institutions serving
the Households and
private Non
Financial
Corporations
Economic Survey, 2021
United States (1987 – 2019)
Source: BEA (US)
Government net
Balance =Total
Government
Receipts Total -
Government
Expenditure
Private Sector
Net Balance=
Gross Private
Domestic
Investment -
Gross Private
Savings
(Domestic
business,
households &
institutions)
Economic Survey, 2021
 Trends in Government and Private sector
balances India (FY 1987 – FY 2019)
Economic Survey, 2021

Source: RBI, MoSPI

Note: Govt net balance = (Public Sector Financial & Non-Financial Corporations and General Govt Gross
Domestic Saving) – (Public Sector Financial &Non-Financial Corporations and General Govt Gross Capital
formation)
Private sector net balance = Private sector Gross Domestic Saving – Private sector Gross Capital formation
For Households, total savings does not include gold and silver (to make it comparable).
• A supply shock is a
disturbance in the Supply Shocks
economy whose first
impact is a shift in the
AS curve (Price Shock)

Price
• An adverse supply shock
is one that shifts AS E’
inwards
– As AS shifts to AS’, P SRAS
equilibrium shifts E
from E to E’ and
prices increase while
output falls
– The higher
unemployment at E’ AD
forces wages and
prices down until
return to E, but Y
Y*
process is slow 
Pt 1  Pt e1 1   (Y  Y * ) 
• To address the economic
slowdown, the Supply Shocks: Policy 1
government may use
fiscal/monetary tools to
raise the AD

Price
E’’
• The cost of this policy is
the higher inflation in E’
the medium run, which
might get entrenched in P SRAS
the expectations leading E
to permanently higher
inflation
AD’’
AD

Y
Y*

Pt 1  Pt e1 1   (Y  Y * ) 
• To address the inflation, Supply Shocks: Policy 2
the government may use
fiscal/monetary tools to
reduce the AD

Price
• The cost of this policy is
E’
higher unemployment in
the medium run.
P SRAS
E’’ E
• The higher unemployment
at E’’ forces wages and
prices down until return to E’’
E, but process is slow
AD
AD’
Y
Y*

Pt 1  Pt e1 1   (Y  Y * ) 
• Stagflation is a
term coined to Stagflation
mean concurrent
high
unemployment
(“stagnation”)
and high
inflation.

• In 1982
unemployment
was over 9
percent and
inflation was
approximately 6
percent (point S)
• How stagflation
occurs?
• Economy is on a short-
Stagflation
run Philips curve that
includes significant
expected inflation

• How to address the

stagflation?
• A recession will push
actual inflation down
below expected
inflation (e.g., a
movement to the right
on the 1980s
• If the inflation can be
maintained at those
levels, then
expectations can be
modified.
• To bring down the Fighting Stagflation
inflationary expectations,
the fiscal/monetary
contraction shifts the AD

Price
inward
• It induces a recession,
bringing the price E’
expectations downward
• The reduction in P SRAS
wages/prices shift the AS E’’ E
outward, and restore the
fully employment E’’

AD
AD’
Y
Y*

Pt 1  Pt e1 1   (Y  Y * ) 
 Unemployment
• The greatest cost of
unemployment = lost
production
– This cost is large: a recession
can easily cost 3-5% of GDP
and hundreds of billions of
dollars
– Okun’s law states that 1 extra
point of unemployment costs
2% of GDP
– Costs borne unevenly,
largely by those who lose
their jobs
– Workers just entering the labor
force and teenagers are
amongst the hardest hit
 What is the cost of disinflation?
The Sacrifice Ratio
• The sacrifice ratio is the percentage of output lost for each 1-point reduction
in the inflation rate.

• If the policymakers are credible enough then the sacrifice ratio will be smaller
– Say the RBI announces that it will stop/slow money supply growth to fight the inflation
– If the people find this promise credible, then the employees will not ask for wage
hikes (the existing nominal wages will maintain their real wages)
– The prices and AS do not change. AD remains at the initial position. Thus, no loss of
output

• What if the credibility of the promise by RBI is low:

– The wage hikes to keep expected real wages constant shifts the AS leftward.
– Since there is no change in the money supply and AD, the output declines.
– Only after realizing the credibility of the RBI’s promise the inflation expectations are
adjusted, shifting AS back to original position
Credible Policy Non-Credible Policy
 CPI
Stagflation in the US Year
Inflation
(%)
Unemployment
Rate (%)
1973 6.2 4.9
• The US had experienced high
inflation during the 1970s due to oil 1974 11 5.6
crisis and the monetary expansion 1975 9.1 8.5

• In October 1979, Paul Volcker 1976 5.8 7.7

announced that monetary policy 1977 6.5 7.1
would aim to reduce inflation. 1978 7.7 6.1
• Nominal interest rates on three- 1979 11.3 5.8
month Treasury bills rose 14.0 1980 13.5 7
percent by 1981 1981 10.3 7.5
1982 6.1 9.5
• A period of tight money brought the 1983 3.2 9.5
inflation rate down to 3.2 percent by 1984 4.3 7.4
1983
1985 3.6 7.1
• The higher unemployment and the lost 1986 1.9 6.9
output was the sacrifice made for
1987 3.6 6.1
disinflation
 Crisis of 1965-67
• India suffered two massive droughts in 1965 and 1966

NDP PC
(billion Income g PC
Net Net Year INR) (INR) g NDP Income
Year production imports
1962 137.3 309.3   
1961 72 3.5
1963 139.9 308.2   
1962 72.1 3.6
1964 147.7 318.3 2.6 0.4
1963 70.3 4.5
1965 158.8 335.1   
1964 70.6 6.3
1966 150.8 310.9   
1965 78.2 7.4
1967 152.3 307.9 1 -1
1966 63.3 10.3
1968 166.1 328.2 9 6.9
1967 65 8.7 1969 171.5 331.1 3.3 0.7
1968 83.2 5.7 1970 180.9 341.9 5.5 3.8
1969 82.3 3.8 1970-71 188.6 348.6 4.3 2
1970 87.1 3.6 PC= per capita
Million Tonnes Joshi & Little, 1994, p. 96 (Bhagwati and Srinivasan, 1975, p.6)
 Fiscal Indicators (% of GDP)

 Indicator 1965/66 1966/67 1967/68 1968/69 1969/70 1970/71

Public investment 8.5 7.2 6.7 5.9 5.6 6.5

Government consumption 8.8 8.5 8.1 8.4 8.5 8.5

Public saving 3.1 2.3 1.9 2.3 2.6 2.9

Public deficit (gap between
investment and saving) 5.4 5 4.8 3.6 3 3.6
Consolidated government fiscal
deficit 6.7 7.3 5.5 4.4 3.8 4.6

Table 4.2, Joshi & Little (1994)

 1973-75 Crisis
• Oil crisis and unfavorable terms of trade led to
deterioration in the balance of payments.
– Oil prices went up from USD 3/bbl to USD 12/bbl between
1973 to 74
– Oil prices further went upto USD 35/bbl in 1979

• Inflation was at its height between mid 1973 and

September 1974, running at annual rate of around 33
percent

• Prices increased across the board, those that mattered

most being oil, fertilizers, and food.
 Snapshot of Macroeconomic Indicators
Item 1971 1972 1973 1974 1975 1976 1977 1978 1979
Real GDP 5 1 -0.3 4.6 1.2 9 1.3 7.5 5.5
Food Production 8.6 -1.3 -8.2 7.8 -5.4 22 -9 15.5 4.3
Foodgrain Availability 4.5 5.4 2 -7.7 9.4 -8 14.3 -3 11.4
WPI (Overall Index) 5.5 5.6 10 20.2 25.2 -1.1 2.1 5.2 0
WPI (Foodgrains) -0.7 3.4 15.6 18.7 38 -11.1 -12.3 11.1 1.8
WPI (Food Articles) 2.6 1.1 10.1 22.7 26 -4.9 -5.1 11.8 -0.7
WPI ( Non food Agriculture) 7.6 -1.4 9 36.4 11.7 -14.6 19.7 6.3 -4.3
WPI ( fuel, Power and Light) 5.9 4 18.6 51.8 10.5 5.3 1.5 4.5 4.5
WPI (Manufactured Products) 7.4 9.5 11.3 14.4 21 1.4 2.3 2.3 0.1
CPI (Industrial Workers) 5.1 3.2 7.8 20.8 26.8 -1.3 -3.8 7.6 2.2
 Controlling Inflation
• Excise duties were increased on a wide range of goods,
including petroleum products.

• Rail fares and other administered prices were increased.

• All wage and salary increases of workers in the organized

sector were frozen; 50 percent of dearness allowance
payments to the same group were also frozen.

• All income tax payers were required compulsorily to deposit

between 4 and 10 percent of their taxable incomes with the
Reserve Bank.

• Dividend distributions by companies were limited to 33

percent of profits.
 Fiscal Indicators : Consolidated
Government (only Budget)
Percentage of GDP at market 1970- 1971- 1972- 1973- 1974- 1975- 1976- 1977- 1978-
Prices 71 72 73 74 75 76 77 78 79
Current Expenditure 13.3 15.1 15.4 14 13.5 15 16.3 15.6 16.7
Capital Expenditure 4.9 5.1 5.1 4.5 5.7 6.9 7 6.4 7.1
Total Expenditure 18.2 20.2 20.5 18.5 19.2 22 23.3 22 23.8
Revenue 13.6 14.9 15.3 14.2 15.1 17.4 18 17.1 18
Fiscal Deficit 4.6 5.3 5.2 4.3 4.1 4.6 5.4 4.9 5.7
Primary Fiscal Deficit 4.3 4.8 4.8 3.8 3.5 3.8 4.7 4.5 5
 The 1979-81 crisis
• Causes: a disastrous harvest, a jump in the price of imported oil
– Price of imported crude rose from $ 13/bbl in 1978 to $ 34/bbl in 1981, and
there was disruption in domestic oil production due to agitation in Assam
– Food grain production

Year 1978 1979 1980 1981 1982 1983

Net production 111 115 96 114 117 113

• Outcome: inflation and a large current account deficit.

– Prices were almost stationary in 1978/79 but increased by 17 and 18 percent
in the following two years.
– The current account was in surplus in 1978/79 but went into a deficit of about
26 percent of exports in 1979/80 and 30 percent of exports in 1980/81.

• The origin of the crisis was remarkably similar to that of 1973.

However, the outcome was quite different.
 Fiscal Indicators: Consolidated Government (% of GDP)

Item 1977/78 1978/79 1979/80 1980/811981/82 1982/83 1983/84 1984/85

Current Revenue 17.1 18 18.6 17.5 18.1 18.6 17.8 18.6

Current Expenditure 15.6 16.7 17.8 17.4 17.4 18.8 18.9 20.5
Balance on current
revenue 1.5 1.4 0.8 0.1 0.6 -0.2 -1.1 -1.9

Capital expenditure 6.4 7.1 7.2 8.2 7.4 7.1 7.1 7.8

Total expenditure 22 23.8 25 25.6 24.8 25.9 25.9 28.2

Fiscal deficit 4.9 5.7 6.5 8.1 6.7 7.3 8.2 9.7

Source: Joshi & Little (1994), Table 6.13

 COVID-19 and Recovery
• Will the economic recovery be led by profits or wages?
The answer matters because it has implications for
aggregate demand in the coming quarters.

• Q2 FY21Corporate results
– Decline in sales, but double digits operating profits growth.
– Net profits grew even faster.
– Large firms achieved this by slashing costs.

• Higher operating profits in a shrinking economy suggest

that the share of wages has come down.
 The classic fallacy of composition
• Survey shows that companies have reduced employee
costs through either salary cuts or lay-offs.

• Sixty-six percent of these CEOs were worried about

reduced consumer purchasing power.

• This is the classic fallacy of composition in economics,

where what is rational for one company may not be
rational for all of them.
 Macroeconomic Impact of Higher or Lower
Wages: Ideological Divides

• Left: Higher wages expand the purchasing power of those

with the highest propensity to consume, thus expand the
domestic demand and output

• Right: Higher wages leads to an inflationary spiral as

companies respond to an increase in employee costs by
increasing the prices of their products.
 Reality is more nuanced:  
A lot depends on the context
• Higher wages
– will not improve aggregate outcomes in an economy with
low unemployment as well as minimal excess capacity
(1970s).
– will stimulate the economy when there is slack (GFC, 2008)

• Higher profits
– will not lead to higher investment demand if there is
significant excess capacity.
– Will lead to higher investment and shift the Aggregate
supply rightward when the economy is operating at full
employment
 Hysteresis and Natural Rate of Unemployment

• Persistent unemployment rate above the NAIRU might raise the

natural rate of unemployment itself

• Long unemployment spells might signal to firms that a worker is

undesirable, and the firms might avoid hiring such workers. The
skills may also get obsolete.

• Unemployed could become discouraged and not vigorously seek

work

• Thus, the ‘scar’ of persistent unemployment may last longer

 Political Business Cycle Theory
• Interactions between economic policy decisions and political considerations
• Building blocks:
1. What are the tradeoffs from which a policymaker can choose?
2. How do voters rate the issues?
3. What is the optimal timing for influencing election results?

• Voters worry about both the level and rate of change of unemployment and
inflation
1. Rising unemployment
2. Inflation that differs from expectations

These worries influence types of policies used

 Political Business Cycle Theory
• Policymaker (politician) wants economy pointing in the right direction at
election time to maximize voter approval
• How to use the period between inauguration and election to bring the
economy to just the right position?
– Use restrictive policies early to raise unemployment and lower
inflation
– As election approaches, use expansionary policy to lower
unemployment

Should be a systematic cycle in unemployment

Aabrams, Burton A.; Butkiewicz, James L. “The
Political Business Cycle: New Evidence from the
Nixon Tapes,” Journal of Money, Credit and
Banking, March April 2012
 Factors work against Political BCT
• Ability of government to time the fine tuning of the economy is
limited
• Difficulties specific to the implementation of politically
motivated manipulations
– Midterm elections
– Risks associated with cynical manipulation of macroeconomic
policies
– Macroshocks overshadowing election cycle
– Executive branch does not control full range of instruments
– Rational expectations