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Inflation vs Unemployment



In a healthy economy, prices tend to go up – a process called inflation. In economics, inflation is a general rise in the price level in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. While you might not like that as a consumer, moderate price growth is a sign of a healthy, growing economy. And, historically at least, wages tend to go up at about the same pace during periods of inflation. The U.S. Federal Reserve sees 2% inflation as the sweet spot for the economy. Of course, whether inflation is high or low, there is no guarantee that it won’t go higher… or lower. So there is always some uncertainty. In an effort to eliminate uncertainty, the FED has set a target rate of a steady 2% inflation. It has not always been successful in achieving that goal because there are a variety of conflicting factors at play in a large economy and sudden shocks like a market crash can cause massive shifts in the money supply.

In the first half of 20th-century economist generally believed that Inflation and Unemployment are two different independent problems of the economy. In 1958 a British Economist A.W. Phillips challenged this assumption when he analyzed the relationship between wage inflation and unemployment. He observed that there was a strong inverse relationship between both of these. The inverse relation between these quantities means that the more of one that exists, the less of the other exists and vice versa. In Principle, the Philips curve gives a deterministic relationship between Unemployment and Inflation. Meaning that amount that exists of one quantity depends entirely upon the amount that exists of the other quantity. Thus Government cannot simultaneously control both of these together. However, the Phillips curve has fallen off in recent years as a way to accurately predict unemployment. The relationship has not been seen to be as stable or as strong. Basically, data from 1970 and onwards has messed up the idea of this theory. We even had deflation in some countries, and a record low unemployment.

The two primary causes of Inflation are:

Excess money supply in the economy

Excess Purchasing power in the hands of people

If both these factors are brought under control, then it is much easy to bring Inflation down.

There are several ways through which it can be controlled but the main way of maintaining it is by the monetary measures. (Monetary Measures – These are adopted by the central bank of the country to control the money supply. It includes an increase in bank rates, sale of government securities in the open market and an increase in cash reserve ratio, etc.).

The vast majority of developed countries are currently reporting a headline inflation rate of below 2%, with the trend in virtually all of them headed downwards.

Inflation rate in India was 5.5% as of May 2019.This represents a modest reduction from the previous annual figure of 9.6% for June 2011.

In fact, inflation has been on the rise for last nine months. While RBI continues to take an accommodative stance in monetary policy reviews to support growth, it is now looking up to government to use duties and other measures.

Here are RBI's four assumptions for keeping the inflation under check:

Lifting of lockdown to remove supply side disruption

COVID-19 cases are gradually coming down and states are also removing lockdown restrictions. This is good news as supplies would improve and prices also settle at lower levels. The RBI Governor today said that a small window is available for proactive supply management strategies to break inflation spiral being fueled by supply chain disruptions.

Intervention from government to reduce import duties or indirect taxes

The RBI is also expecting government to intervene to reduce price pressure. Take for instance; the government has recently reduced import duties on edible oil. Similarly, the government also cut import duties on masoor dal. Any duty reduction by government will bring a relief to consumer from high inflation.

Action against hoarders

The RBI for the first time made a mention that "substantial wedge between wholesale and retail inflation points to the supply-side bottlenecks and large margins being charged to the consumer."  This is a very big statement that higher margins are being charged by retailers from consumers. The state as well as central government has to come forward to take action against such retailers or hoarders. The government should direct investigating agencies to act against those accused of profiteering.  

Scaling down RBI's liquidity tap

The RBI has kept away from infusing more liquidity into the system, though it said it has many tools to step in as and when necessary. As of today, the higher liquidity both in global markets as well as domestic market is finding its way into equity markets and asset prices.  The equity markets are at an all-time high. Higher liquidity also has the potential to fuel inflation in the longer run.

Why controlling Inflation is more important than controlling unemployment?

Since both of these are interrelated, it is only possible to control one at a time, and controlling Inflation is an easier task for any government.


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References:

  1. weforum.org

  2. wikipedia.com

  3. inflationdata.com

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