Understanding Philips Curve And Its Implications On Inflation And Unemployment

Short-run and long-run Philips curves

Question:

(1) Explain whether there is a relationship between inflation and unemployment. Should government interfere and reduce inflation and unemployment? Provide real life examples. 
(2) Using your home country as a case study outline and analyse inflation, unemployment and growth trends. Identify what range of the aggregate supply curve your country is operating in. 
(3) Explain how monetary policy can influence an economy, including the exchange rate and employment levels

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(1) Economics covers various facets and aspects related to the people and the country and their markets. In order to understand the relationship between inflation and unemployment we need to know what exactly they are. Inflation is studied under economics and is a condition where the price of goods rises, or we can say that it is a general rise in the price of goods. This can take place due to various factors like shortage or supply or excess in demand but nevertheless we see that the price of everyday commodity rises. It is usually defined as a situation when “too much money chasing too few goods”. Unemployment is another term that we all hear in our day to day life these days. Unemployment is a condition where a person who is capable of working or rather is of workable age, but still does not have any work, or is jobless. Despite of having the capacity to work, the person does not have work, and this too can be because of various reasons, and is or various types like, voluntary and involuntary and others. What we need to discuss is how exactly inflation is related to unemployment. In economics it is described in various ways and Philips curve is one of the ways used to describe the relationship between inflation and unemployment. Historically and ever since economics have been taken up as a study we see that Philips curve has described inflation and unemployment to be something which have been inversely related, that is, higher rate of inflation would mean lower rate of unemployment which means that there would be more employment.

Given above is a graph that tells us about Philips curve and how it establishes the inverse relationship between the rate of inflation and the rate of unemployment.

Earlier it was much easier and simpler to establish the relationship between these two but with time, and keeping today’s economy in focus, we now see that Philips curve too has been divided into categories like “short-run Phillips curve” and the “long-run Philips curve”. 

Philips curve can also be represented mathematically with the below given equation-

“Inflation = [(expected inflation) – B] x [(cyclical unemployment rate) + (error)] 
where B represents a number greater than zero that represents the sensitivity of inflation to unemployment.”

The logic behind this kind of inverse relation is that inflation usually is marked with a situation where the demand is high and the supply is short, which then again because of various reasons. When the demand rate is higher we see that the companies and the industries try to produce more of the required good and increase the supply marginally in the market. In order to increase the rate of supple, they need more labor and more people to get involved in the company so that they can produce more. And when more people are required in a particular company we see that the section of people who were unemployed find jobs in the various companies and thus with the increasing inflation we see that the rate of unemployment comes down.

Mathematical representation of Philips curve

When we have to consider a real life economy to explain what has been stated above us that in the US and there was a trade off.

The above diagrams show how the rate of unemployment has increased over the years as the rate of inflation has decreased.

“Between 1979 and 1983, we see inflation (CPI) fall from 15% to 2.5%. During this period, we see a rise in unemployment from 5% to 11%.

In 2008, we see inflation fall from 5% to -2%. During this time, we see a sharp rise in unemployment from 5% to over 10%.” (Pettinger, 2011)

The main aim of the governing body of a state is that it tries to keep both, the rate of inflation and the rate of employment low. The rate of inflation has to be kept low so that the people can buy the things that they need without it being very expensive and at the same time the rate of unemployment needs to decrease so that the mass majority of the people of any state can earn their own living and do not face the consequences which arise due to not having enough money to survive because of this unemployment.

What we know is that when an economy has a free market and the market mechanisms function freely without the intervention of the government it is seen that the rate of inflation keeps going higher and higher and that the rate of unemployment is decreases only a little compared to the rising rates of inflation, and the reason which has been given above already tells us as to why the government interferes and decreases both the rates, and how it needs to for the betterment of the people of both sides. Hence we see that the government uses certain policies and brings down the rate of inflation and the rate of unemployment.

The policies that the government uses to reduce the unemployment of a state may include-

• Fiscal policy
• Monetary policies
• Improving the mobility in the territory for the people
• Education and training for the people so that they can be employed
• Subsides for employment, etc.

Polices to reduce inflation may include-

• Wage control policies
• Monetary policies
• Fiscal policies
• Policies dealing with the exchange rate of the state
• Policies related to supply in the economy.

The above policies were seen to be implementing by the United States of America in the above mentioned case when the inflation and the rate of unemployment both were in an inappropriate scale. Hence to bring them both to a stable level the government had to interfere and implement certain policies so that both the rate unemployment and the rate of inflation would come down. 

(B) To answer this question, India has been taken as the home country where the analysis of inflation, unemployment and growth trends is taken up for the study. Besides further the supply curve working in the country is also analyzed.

We have already discussed as to what inflation is and how it increases or decreases. India though is a developing country we see that since the time of independence it has improved far better than the rest of the economies of the world and at this point of time is the if nominal GDP is concerned the economy of India is the tenth largest in the whole world. There are different sectors which function in this economy and most of the drawbacks that this country faces are due to the colonial era that it had to face. Apart from that we have seen the rise in inflation in this country too.

Causes of inflation and unemployment in India

“The annualized inflation rate in India is 6.46% as of September 2014, as per the Indian Ministry of Statistics and Programme Implementation. This represents a modest reduction from the previous annual figure of 9.6% for June 2011” are the rates of inflation which have been given in the context of this country.

Definition of inflation in context for India’s economy is given as “the percentage change in the value of the Wholesale Price Index (WPI) on a year-on year basis. It effectively measures the change in the prices of a basket of goods and services in a year. In India, inflation is calculated by taking the WPI as base” and the mathematical formula for this is-

(WPI in month of current year-WPI in same month of previous year)
————————————————————————————– X 100
WPI in same month of previous year

There are several reasons as to why the inflation factor is playing a role in the Indian economy. India is a country that uses WPI as the base for the calculation of inflation. On one hand we see that the authorities are trying to get the inflation rate in control and at the same time we see that there are undeniable reasons for inflation that exist. There are few very significant reasons as to why a developing country like India faces inflation and they are-

• Population: one of the main reasons of inflation in India is the growing population. More are the number of people in a country more will be the mouths to feed, and hence more will be the demand for every day commodities. This surplus increase in demand is what leads to inflation.
• Spending capacity: with the trend that is being followed in the country we see the common man now has more money to spend. More is this circulation of money in the economy, more is demand for commodities, and this kind of demand again creates inflation.
• The growth of economy which is unbalanced: though India has been growing at a fast rate, the contributions from different sectors are uneven. “The contributions towards economic growth from the primary (agriculture), secondary (industry) and tertiary (services) sectors are 17.2%, 26.4% and 56.4% respectively” (Jindal). Hence this means that the average contribution of each sector is less, which makes us import a large amount of goods that leads to weak INR, which is one of the reasons for inflation.

The above figure shows the unemployment rate in India.

Another phenomenon which has been commonly seen in unemployment. India is the seventh largest country in the world with a population of 1.252 billion (2013). This is one of the main reasons why unemployment is widely seen in India. “Unemployment rate in India is showing an increasing trend since 2011 when it was 3.5%. The same rose to 3.6% in 2012 and climbed to 3.7% last year” (Unemployment levels rising in India, experts say, 2014)

There are types of unemployment in India beside voluntary and involuntary and they are-

• Frictional unemployment
• seasonal unemployment
• Open unemployment
• Disguised unemployment

The main reasons why India faces unemployment are-

• The main reason has already been given which is the huge population of the country which is growing more and more rapidly with the passing years.
• Another reason is that though the population is growing there is the limited piece of land which is not being enough to sustain the peoples need.
• There has been a decline in the cottage and the small scale industries which is leading to unemployment.
• The agriculture sector which employs most of the people is a seasonal job which leads to seasonal employment.
• Backward and traditional methods of agriculture are also a factor which is leading to unemployment.
• The farmers have small fragments of land due to land fragmentation which again is another factor.
• Low rate of literacy
• Lack of infrastructure and transport and communication.

There are many other reasons, but the important ones have been mentioned above. The growing trends of India are better than any other developing country.

The figure below shows us the aggregate supply curve which functions in India.

The aggregate supply curve is the output that is produced by the country in a given period of time or in the long run. It also in a way represents the potential output which can be achieved by the country in the long run. When we look at the country about which we have been talking about we see that it follows the pattern which is depicted in the above graph, there are different factors which play different roles in the long term supply curve aggregate and different in the short run supply curve aggregate.

The figure above shows the relation between the different demand and the supply. Hence it can be clearly seen that all the factors discussed above are inter related.

[c] Before we discuss how the monetary policies can influence an economy and the different factors which operate in the economy we need to first understand what exactly is a monetary policy and how the government uses it to control various situations as and when they arise. By the name itself we can understand that it has to do something with the money that is circulating in the economy. It is usually the policies that have been laid down by the Central Bank of the state and deals with controlling the money supply of in the economy by making certain regulations. The government of the State manages the money circulating in the country by making use of certain factors like the demand side, the money supply and the interest rates of the economy and this is a matter which is dealt under macroeconomics. This kind of monetary policies made by the government influences the economy still a great extent and also different factors which are related to the economy like the exchange rates and the employment/unemployment of the country. The ways that the monetary policy of the country influences and affects the economy has been listed below-

• The monetary policy affects the interest rate of the economy. Decreased rates induce more circulation of money as the loans taken from the banks by people are more and hence the overall demand in the economy increases. Besides this also leads to fewer saving and more expenditure in the economy. This means that the purchasing power of the people increases. This in the long run might also lead to inflation as the demand for everyday commodity will increase rapidly, whereas because of this kind of demand the supply of these items have been decreasing rapidly.
• The above point leads us into the second most important factor which is affected by the monetary policy which is that of the employment. We have already discussed that monetary policy when is dealing with the rates, decreases the rates and increases the rates according to what is the condition of the economy. When we consider a situation when the central bank of the state has decreased the overall rates, we see that more and more people are encouraged to borrow loans from the banks for different purposes. This kind of loans puts a lot of money in the economy and in the hands of the people, which means that there is more circulation of money which increases the purchasing power of the people like it has been mentioned above. This kind of purchasing power makes the people increase the demand for the day to day goods and even the luxuries, which in turns decreases the supply of such items. In order to combat the increasing demand of the people the industries try and employ more and more people so that their output can increase and the demands of the people can be met. In order to carry this out they employ more people. The reverse happens when the interest rates are increased. Hence we see that the monetary policies affect the employment rate of the economy.

Government policies to reduce inflation and unemployment

The given figure summarizes the points that have been made above.

• The main reason why monetary policies function is so that the economic stability is maintained in the economy which can only be done by keeping a check on the money supply in the economy. “”Ideally monetary policy aimed at price stability results in economic activity close to its sustainable maximum at all times, with no costs to employment at all. This is what we strive for. ” — Dr Don Brash
• It has also been noted that the monetary policies affect the exchange rates of the country. Exchange rate is usually the value of the currency of country against the value of the currency of some other country. When the exchange rate is more that means the value of one’s currency is more against the other, and reverse means the value of one’s currency is less.
• It has also been noticed that the monetary policies of a country is directly related to the exchange rate which is functioning in that country.

The figure given above shows the relation which is there between the exchange rates and the interest rates which is a direct result of the monetary policy.

We can take the case of the monetary policy when the rates are reduced. We have already discussed that the monetary policies are capable of decreasing the interest rates of the country. This in turn makes the domestic field less attractive for the foreign investors but the domestic investors thus will become more interest in the foreign field. This will lead us to the point where there will be a decrease in demand for the domestic currency by both the investors and in turn there will be a significant increase in the demand of the foreign currency as both the foreign investor and the domestic investor would like to deposit their money there. This will obviously decrease the value of the domestic currency and the exchange rates will get affected as the value of the foreign currency will increase significantly. This is how we know that the monetary policies affect the exchange rates as well. Besides this is what happens when there is more circulation of money in the economy because of low exchange rates, that is the expansionary monetary policies but the opposite happens when the exchange rates is high and when the monetary policies formed by the government is tight. Hence the monetary policy affects the different aspects of the economy depending upon how the government plans to use it. The exchange rates can also be turned into a platform where it would favor the domestic currency by increasing the rate of interest which in turn will increase the value of the domestic currency. 

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