Inflation &Unemployment

Introduction
 Inflation is a major economic problem, which plagues most of the countries in the world
today.
 Inflation is a persistent and an appreciable increase in the general level of prices.
 This 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 the opposite of inflation. It is a situation where there exists a persistent
decrease in the general level of prices. It leads to a Increase in the purchasing power of
money.
Measurement of Inflation:
1. Two price indices used to measure inflation are:
CPI: Weighted average of prices of specified baskets of G&S
which are purchased by consumers
WPI: Producer Price Index measures the changes in the average
price of goods which are traded in wholesale market.
2. GNP deflator: Can be obtained as follows:
GNP deflator = Nominal GNP/ Real GNP
Nominal GNP = GNP at current prices
Real GNP = GNP at constant prices
Rate of inflation can be measured through change in price index:
𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡 −𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑡−1)
Rate of Inflation =
𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑡−1)

Where, t = time period, which has been selected for measuring

inflation
t - 1 = the preceding year
For example: If CPI was Rs150 for 2006 and Rs165 for 2007
Inflation rate equals
*(165-150)/(150)) * 100 = 10%, which is a high rate of inflation
Calculating Inflation – An Example
 To better understand how inflation is calculated we can use an example. In this example we calculate inflation for a
basket that has two items in it – books and childcare. The formula for calculating inflation for a single item is
below.

Items 2016 2017 Inflation

$20 $20.50 2.5%
$30 $31.41 4.7%

 The price of a book was $20 in 2016 (year 1or t-1) and the price increased to $20.50 in 2017 (year 2 or t). The
price of an hour of childcare was $30 in 2016, and this increased to $31.41 in 2017.
 Using the formula, inflation for each of the individual items can be calculated.
 For books, annual inflation was 2.5 per cent
 For childcare, annual inflation was 4.7 per cent
 To calculate inflation for a basket that includes books and childcare, we need to use the CPI weights that are based
on how much households spend on these items. Because households spend more on childcare than books, childcare
Items 2016 2017 Inflation
has a greater weight in the basket. In this example, childcare accounts for 73 per cent of the basket and books
$20 and$20.50
account for the remaining 27 per cent. Using these weights, the change 2.5%
in prices of the items, annual inflation
for this basket was 4.1 per cent – calculated as (0.73 x $30 $31.41
4.7) + (0.27 x 2.5). 4.7%
 Economic and Social effects of Inflation:
 In an economy where all prices change proportionately, no one is hurt and no
one gains due to the changes in the price level.
 However, in the real economy all prices do not change proportionately.
 While some members of the society gain from inflation, others may loose.
 We can analyze the effects of inflation under two categories, economic effects
and social effects
I. Economic Effects of Inflation:
 1. Distribution of Income: The impact of an increase in the general price level
is felt unevenly by the different groups of people, some of whom can be called
the gainers whereas the others can be called the losers from inflation.
 A. Gainers:
 Producers as a group who derive income from profits
 Investors in equity
 Debtors benefit due to decrease in value of money reduces the burden of
interest owed by them.
B Losers from Inflation:
1. The wage and salary earners who are without labour unions.
2. Those who invest in fixed interest yielding bonds.
3. Creditors lose because the real worth of interest that they get from debtors goes down
4. Rent earners,
2. On Distribution of wealth:
A household’s wealth depends on the difference between the value of its assets and its
debts.
The assets can be divided into two categories:
1. Variable price assets include all types of physical assets like property, gold and silver
jewellery, and financial assets like shares.
To what extent does the household gain from these assets depends on the increase in the
price of these assets vis-à-vis the inflation rate.
2. Fixed claim assets include bonds, money, debentures and bank deposits. The money
value of these assets is fixed in terms of money
Household holding variable price assets gain as their prices adjust with rising inflation.
Fixed claim assets lose their worth due to rising inflation.
3. On output and Employment
 Economists believe that a inflation, below full employment, of the
creeping or crawling type may prove to be favorable as long as it is
unanticipated.
 The prices increase at a faster rate than the money wages resulting in
higher profits and also providing an incentive to the firms to expand the
output by hiring more workers. Thus at least in the short run inflation, if
unanticipated, will lead to an increase in employment and thus in the
output.
 However, in the long run once money wages catch up with rising prices,
labour finally anticipates the inflation and succeeds in increasing real
wages and unemployment reappears.
II Social Costs of Inflation:
 Besides the economic effects, inflation has some social effects also which
result in problems for the society. To understand these problems, it is
important to differentiate between the two types of inflation
 Perfectly anticipated inflation: when the rate of inflation is steady and
perfectly predictable. for example, every month there is an increase in the
price level, say by 2 per cent.
 Such inflation imposes certain costs on the society. These costs are:
A. Menu cost: With a high rate of inflation, firms are expected to adjust their
announced prices. This involves making changes in the catalogues and cash
registers. The costs involved in these changes are called menu costs.
B. Shoe leather cost: Frequent visit to banks or ATM
C. Distortion in taxes: In tax provision, tax is on nominal income not on real
D. Inconvenience in using money as a yardstick: Measuring economic
transactions with changing value of money (Rupee)
2. Imperfectly anticipated inflation: The inflation which people do
not expect.
A. An arbitrary redistribution of wealth: Household with fixed
interest yielding assets lose
B. An unfavorable effect of decision making: Induces an element of
risk in transactions.
Theories of Inflation:
 One of the key economic questions that economists are concerned
with are the causes of inflation. It is only after understanding the
causes that attempts can be made to control it and keep it under
acceptable limits.
 Keynesian Approach to inflation:
 Keynes presented the excess demand in terms of inflationary gap in
his book ‘How to pay for war’ in 1940.
 The inflationary gap is the amount by which the aggregate demand
exceeds aggregate output at full employment level.
 Since the output cannot be increased beyond full employment, the
prices will increase leading to demand pull inflation.
 Keynes theory is non-monetary theory- does not consider changes in
monetary sector.
 AD

AS

C+I+G+∆G

C+I+G
Inflat. gap

Yf Income
In order to reduce inflationary gap, either reduce G or increase T.
Modern Approach to inflation: According to Modern theory, price
level is determined through AD and AS.
Thus, changes in the price level can be related to changes in the
aggregate demand and the aggregate supply.
Demand Pull Inflation: When increase in price level is due to increase
in aggregate demand.
Cost Push Inflation: When increase in price level is due to increase in
aggregate Supply.
Demand Pull Inflation:
Assumptions:
1. The AS slopes upward to the right and then becomes perfectly
inelastic at full employment.
2. The economy is at Full Employment, any shift in AD only affects
price level.
In terms of IS-LM excess Demand that further leads to an increase in
the price may occur due to
1. Increase in G, shifting IS to right
2. Increase in Ms, shifting LM to right
Demand pull inflation arising from real factors:
1. G increases.
2. T decreases
3. I increases
4. S decreases
5. NX increases
The analysis would be
the same with any of
the other factors
discussed above, which
lead to a rightward
shift of the IS curve.
Demand pull inflation arising from monetary factors:
1. An increase in MS.
2. A decrease in Demand
For money
 Therefore, For a persistent increase
in the price level, there should be a
persistent increase in the money
supply.
 The analysis would be the same
with any of the other factors
discussed above, which lead to a
rightward shift in the LM curve.
Inflation: Supply side
Cost Push inflation
1. Wage push inflation
2. Profit push inflation
3. Supply shock inflation
Control of inflation: As far as the demand side inflation is concerned, restrictive
monetary and fiscal policies are commonly used to control the inflation.
Any increases in investment, government expenditure or foreign expenditures that
lead to a rightward shift of the aggregate demand curve leading to an increase in
the price level can be counteracted by restrictive monetary and fiscal policies.
This is because such policies have an immediate impact on the level of the
aggregate demand.
Restrictive MP and FP work for demand pull inflation but not for cost push
inflation.
This is because supply side inflation is caused by rising prices and output below full
employment level. In an attempt to control cost push inflation, carrying out of
contractionary Fiscal policy leads to further fall in output
 Hence, it is apparent that an attempt
P at controlling a supply side inflation
through restrictive monetary and
fiscal policies can be achieved only at
F
p2 the cost of a reduction in the output
G E
p1 AS2 and hence in the employment level.
 Such an increase in the
unemployment may not be socially
AS1
AD2acceptable and may, in fact, result in
AD1 an economic slowdown.
 Thus in such cases, price stability can
Y2 Y1 Yf
Y be achieved only at the cost of an
increase in the unemployment rate
Indexation:
 Indexation is a method by which there is an automatic adjustment of wages
and prices according to the rate of inflation.
 Indexation reduces the reaction of people to inflation.
 Indexed debt is the debt where interest payments are adjusted every year to
account for inflation.
 Unemployment
Unemployment refers to the share of the labor force that is without work but
available for and seeking employment.
Included in this group are those people in the workforce who are working but
do not have an appropriate job.
Employment most generally means the state of having a paid job—of being
employed
Labour force : is a concept referring to the pool of human beings eligible for
work and either in employment or in unemployment.
Labour force participation rate: is defined as the percentage of persons in
labour force (i.e. working or seeking or available for work) in the population
Unemployment = Labour force – No. of people employed
Unemployment Rate :
Unemployment Rate = {(Labour force – No. of people employed) / Labour
force} * 100
Unemployment Pool :
Unemployment pool consists of number of unemployed people at any point of
time.
Frequency of unemployment :
Frequency of unemployment is defined as the average number of times, per
period worker becomes unemployed.
Types of Unemployment
 Frictional Unemployment:
 Occurs when people change jobs, get laid off from their current jobs, take
some time to find the right job after they finish their schooling, or take time
off from working for a variety of other reasons
Causes of frictional unemployment ;
 Sectoral shift is usually a change in the composition of demand among different
industries.
 Workers may find themselves out of work due to many reasons.
Policies aimed at reducing Frictional Unemployment ;
 Efforts should be taken to match jobs and workers
 Retraining programs should be designed.
 Terms of employment insurance programme should encourage workers to take
the job offers.
 A 100% experienced rated system should be in place for which the firm bares
the entire cost of the worker’s unemployment benefits.
 Partially experienced rated system where firm that lays of a worker has to bear a
part of the burden of worker’s unemployment benefits.
Structural Unemployment
 Structural unemployment is a category of unemployment caused by differences between
the skills possessed by the unemployed population and the jobs available in the market.
 Structural unemployment is a long-lasting condition that is caused by fundamental changes in
the economy.
 Causes
 Occurs when workers' skills do not match the jobs that are available.
 Technological advances are one cause of structural unemployment
 Competition
Policies aimed at reducing Frictional Unemployment.
 Quick and Efficient Training
 Breaking Geographical Barriers
 Subsidies
cont…..
Seasonal Unemployment:
Seasonal unemployment refers to a time when people working in
seasonal jobs become unemployed. This happens when the demand
for labor decreases. Many people get unemployed when a specific
time of year ends.
 Causes
Weather Conditions.
Lack Of Industries. ...
Lack Of Commercialization Of Agriculture. ...
Decrease In Demand For Labor. ...
Low Self-Esteem. ...
health issues. ...
 Policies to reduce Seasonal Employment
 Diversify the economy
 Regulations
 Promotion of multiple cropping
Natural rate of unemployment (NAIRU):
 It is the average rate of unemployment around which any economy fluctuates in the
long run.
 The natural unemployment rate is the minimum unemployment rate resulting from real
or voluntary economic forces.
 It represents the number of people unemployed due to the structure of the labor force,
such as those replaced by technology or those who lack the skills to get hired.
 It refers to unemployment which is bound to exist even when labour market is in a'
state of equilibrium.
 The natural rate of unemployment is also known as the constant inflation rate of
unemployment or the non-accelerating inflation rate of unemployment.

 NAIRU = Average of unemployment rate for 10 years earlier to 10 years later.

Policies aimed at reducing NAIRU :
Reduce unemployment benefits
Reduce minimum wages
Incentivise workers to take technical training
Control recession
Phillips Curve: Tread-off between inflation and Unemployment
 The Phillips curve shows an inverse relation
between the rate of unemployment and the
rate of inflation in an economy…
 The lower the unemployment in an economy,
the higher the rate of increase in wages paid
to labor in that economy, which helps fuel
inflation.
 Society Faces a Short-Run Tradeoff Between
Inflation and Unemployment.
 Reducing inflation often causes a temporary
rise in unemployment.
 This tradeoff is crucial for understanding the
short-run effects of changes in taxes,
government spending and monetary policy.
 Philips Curve:
There exists an inverse relationship between rate of
unemployment and wage inflation

Gw= (W – Wt-1)/ Wt-1

Gw: rate of inflation
W= wage in current period
Wt-1 = wage in preceding period
The NAIRU is the amount of unemployment that exists at a level of
full employment. We denote it by U*. The Philips curve can be
represented by:
Gw= -e (U – U*)
e measures the responsiveness of wages to unemployment
U= the unemployment rate
U*= The NAIRU
U-U*= the unemployment gap

If U>U*, the wages would fall

If U<U*, the wages would rise
Philip’s curve Explanation:
1. During low unemployment and tight labour markets (boom
period), firms are generally making profits, aggressive
labour can demand more wage and firms mostly comply
2. During high unemployment periods (recessions) labour loses
it bargaining capacity due to distress and is forced to work at
lower wages
Sacrifice ratio: Percentage of output which is lost for a one point
decrease in inflation rate.
Thus, in the short run, government can reduce inflation only at a cost
of higher unemployment rate.