Monetary policy of a country has a short term impact on inflation
and the economy-wide demand for goods and services. Hence, the demand for the human
resources who produce those goods and services also fluctuates. When monetary
policy is used to reduce inflation, countries face problems to control unemployment.
This scenario was well explained by economist A. W. Phillips in 1958, where he
showed that when inflation is high, unemployment is low, and vice versa. This
relationship is now well known as the Phillips
curve. If an economy experienced inflation, monetary policy is used to curve
the inflation down, either by contracting the money supply or by raising the
interest rates, higher interest rates reduce consumer spending and investment
leading to lower aggregate demand, while aggregate supply remains the same. With
the fall of aggregate demand, inflation would decline. However, if there is a
decline in Real GDP, firms will employ fewer employees leading to a rise in
unemployment.
In the Indian scenario, let's take a look at the relationship
between inflation and
unemployment and see if we can find the Phillips Curve at
work, for this purpose we have studied data points of just 3 years (2010-11,
2012-13, 2013-14, the data points of 2011-12 have not been considered due to unavailability
of unemployment rate in Labor bureau of India).
In 2010-11, the unemployment rate was about 3.8%, while
inflation (WPI) was bit on a higher side 9.7%. Then in 2012-13, we saw a rise in
unemployment to 4.7%% (source: Labor bureau of India), whereas inflation declined
to 5.7% (source: https://data.gov.in/catalog/wholesale-price-index-base-year-2004-05#web_catalog_tabs_block_10).
It has also been observed that,for high GDP growth, unemployment has fallen sharply, for example in 2010-11 GDP
growth rate was at 8.91% and unemployment rate was only at 3.8%, but when GDP
growth rate declined to 4.47% in 2012-13, unemployment rate increased to 4.7%.
In some
periods , It is also possible to have a rise in both inflation and
unemployment. For example, inflation rate increased from 5.7% in 2012-13 to 6%
in 2013-14, and during this period unemployment have also increased from 4.7%
to 4.9%. This implies that it can happen due to cost-push inflation, the
aggregate supply curve would shift and there would be a fall in economic
activity and higher prices. However, we could debate this by the Monetarist view,
but there can be still a trade off. If the RBI sought to reduce the cost-push
inflation through higher interest rates, they could. However, it would lead to
an even bigger rise in unemployment.
By plotting these points on a graph, we can see the normal Phillips curve (unemployment
vs Inflation), which is downward sloping with
following normal linear regression model y = -3.69x + 23.63 with R² = 0.94 and F value=16.86. (** Please note that data points were insufficient to run regression model , minimum of 15-20 observations were required to run that).
Conventionally, the Phillips curve augmented
for expectations of inflation represents the tradeoff between inflation and
unemployment in an economy in the following way: gpT = gpeT - ß (UT
− x̄) + ɛ
where, (gp) is actual
inflation rate, (gpe) is expected inflation rate, (UT
− x̄) is cyclical unemployment
given by the difference of unemployment rate (u) and natural rate of unemployment (x̄) and (e) is an error term. The parameter (ß) measures the
response of inflation to cyclical unemployment. The distance between U and x̄is called
unemployment gap.
But, we would not get a
regular Phillips curve in India because we have to adjust for exogenous factors,some of the studies i.e Paul
(2009) , Patra and Ray (2010) , Manoj Kumar (2012) etc. suggest that extended Phillips curve model can be
applicable for India.