Unit 4

Macroeconomics
1: The
Macroeconomy
Subunit 5: 542
Government
Macroeconomic
Policy Objectives
542

Government Macroeconomic
Policy Objectives
Inquiry Questions for the Unit

1. How does unemployment affect individuals and society as a whole?

2. How do the consequences of unemployment differ based on its type?
3. How does inflation impact the economy and individuals?
4. How can the government use changes in the CPI to inform their macroeconomic policies?

Introduction
Gross Domestic Product (GDP) is an integral macroeconomic variable since it is a measure of
aggregate activity in an economy. But two other variables, unemployment and inflation, tell us
about other important aspects of how an economy is performing. This sub-unit begins with an
exploration of unemployment, a critical global economic issue, discussing its causes, types, and
impacts on individuals and societies. The sub-unit then transitions into the measurement of
unemployment, a crucial aspect for interpreting economic data and assessing policy effectiveness.
Following this, the concept of inflation, a fundamental macroeconomic element, is examined.
Inflation and its types, causes, and effects are discussed, explaining the reasons behind rising
prices and their influence on economic activity. The sub-unit concludes with an exploration
of changes in the price level using the Consumer Price Index, a vital tool for economists and
policymakers, offering valuable insights into the assessment of economic performance.

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5.1 What is Unemployment?

Employment is defined as the utilisation of labour, which is a key component in the production
process. It signifies the economic engagement of individuals in work that contributes to the
overall output of an economy.

On the other hand, unemployment is a state that arises when individuals who are both capable of
working and actively seeking work fail to secure appropriate paid employment. This situation is
not static but rather a dynamic process influenced by various factors.

Unemployment is considered a stock concept, which means it represents a quantity at a particular

point in time. The magnitude of this stock is determined by the rate of ‘inflows’ (individuals
entering unemployment) and ‘outflows’ (individuals exiting unemployment), as well as the length
of time individuals remain unemployed. The interplay of these factors determines the overall level
of unemployment in an economy.

Why Do Economists Care about Unemployment?

Economists are concerned about unemployment for two primary reasons.

Firstly, unemployment directly impacts the welfare of those who are unemployed. Despite the
existence of unemployment benefits, unemployment is often linked with financial hardship and
psychological distress. The extent of this suffering depends on the nature of unemployment.
A common perception of unemployment is that of a stagnant pool, with individuals remaining
unemployed for extended periods. In normal times in India, this image may not be entirely
accurate: every month, numerous individuals become unemployed. While many of these
unemployed people secure jobs again, but what happens when they remain unemployed for

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a longer time than usual? When unemployment rates rise, the image of a stagnant pool of
unemployed workers becomes more fitting. Now, not only are more people unemployed, but many
also remain unemployed for a longer duration.

Secondly, economists are interested in the unemployment rate as it serves as an indicator

that the economy might not be efficiently utilising its resources. Numerous workers who are
willing to work are unable to find jobs, indicating that the economy is not efficiently using its
human resources. From this perspective, can very low unemployment also pose a problem? The
answer is yes. Like an engine running at an excessively high speed, an economy with very low
unemployment might be overutilising its resources and face labour shortages. Determining how
low is “too low” is a complex question.

Unemployment (U) can be expressed as:

U = Workforce - Employed People

where,
Workforce = Population — People not in the Workforce

The term ‘workforce’ excludes certain segments of the population such as preschool-aged children,
full-time students in schools, colleges, and universities, individuals with chronic illnesses, and
retired persons. This leads to the concept of the labour participation rate, which is defined as the
workforce as a percentage of the total population. An alternate definition considers the workforce
as a percentage of the adult population, specifically those aged 15 years and above.

Given these definitions, the unemployment rate (u) is calculated as the ratio of the unemployed
population (U) to the total workforce. I.e.,
U= U
Workforce

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This rate is a critical measure of economic health, indicating the proportion of the workforce that
is actively seeking but unable to secure employment.

In this context, a person is classified as:

a. Employed, if they hold a paid job
b. Unemployed, if they are jobless but actively seeking employment at market conditions
c. Economically inactive, if they are jobless and not seeking employment. These individuals are
not part of the workforce.

Check Your Progress 1

1. For each of the following cases, decide whether the people are employed, unemployed or part
of the economically inactive population:
a. Khuber worked 36 hours last week as an electrician.
b. Cynthia lost her job as a part-time secretary two months ago. Every week she visits a job
centre to try to find a new job. She would be able to start within a week if she found one.
c. Rishabh is out of work. He would like a job but stopped looking three months ago since he
became so discouraged. No jobs seemed to be available.
d. Ideally, Myna would like to work. She is not seeking work at the moment because she is
caring for an elderly relative at home. In any case, she would not be able to start a job till
at least after two weeks.
e. Hritesh works fewer hours than he would like. He became self-employed in the last
recession when he lost his previous job. Although he works, he does look at job adverts in
case something better comes up.

2. Suppose that employment websites enable job-seekers to find suitable jobs more quickly.
What effect will this have on the unemployment rate over time? Also, suppose these websites
encourage job seekers who have given up on job searches to begin looking again. What effect
will this have on the unemployment rate?

3. Answer the questions that follow based on the information for a hypothetical economy
presented in the table below:

Population age 16 and older 200,000

Labour Force 100,000
Number of people working part time 20,000
Number of people working full time 70,000

a. What is the labour force participation rate?

i. 70% iii. 20%
ii. 50% iv. 5%

b. How many people are unemployed?

i. 10,000 iii. 30,000
ii. 20,000 iv. 100,000

c. What is the unemployment rate?

i. 70% iii. 20%
ii. 50% iv. 10%

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The term full employment is used to describe an optimal state in an economy where all
individuals who are willing and capable of working are employed. It is a scenario that
governments aim to achieve, as it allows an economy to utilise its human resources fully.

It should be noted that full employment does not imply that every individual in the economy is
employed. In a dynamic economy, there will always be some individuals transitioning between
jobs (frictional unemployment) and others who opt not to engage in paid employment (voluntary
unemployment).

5.1.1 Natural Rate of Unemployment

The natural rate of unemployment, a concept rooted in monetarist theory, represents the level
of unemployment that corresponds with a stable rate of inflation. When the economy is at
the natural rate of unemployment, the demand for labour matches the number of individuals
willing to offer their labour at the current wage rate. Any existing unemployment at this stage is
considered ‘voluntary,’ stemming from imperfections in the labour market.

This concept can be visualised using the demand and supply model. The real wage, denoted
as ‘w’, is the price of labour, calculated by dividing the nominal wage by the price level. The
demand curve illustrates the quantity of labour demanded at each real wage. The principle is
straightforward: the lower the real wage, the higher the quantity of labour that firms will demand.

On the other hand, the labour supply curve is upward sloping, indicating that as real wages
increase, the labour supply also slightly increases. However, this increase is small due to
constraints such as the available time and skill levels. Thus, the total labour supply doesn’t
increase significantly even with higher wages.

In this model, the real wage (wn) is equivalent to the equilibrium solution, determined by the
intersection of the demand curve (D1) and the supply curve (S1). At this point, the quantity of
labour demanded (Ln) matches the quantity supplied. This employment level, where the quantity
of labour demanded equals the quantity supplied, is termed the natural level of employment.

When the economy is at its natural level

S1
of employment, a certain degree of
Real wage

unemployment, known as the natural rate wn

of unemployment continues to exists.
Additionally, fluctuations in the business cycle
can lead to variations in unemployment levels. D1
Ln
Therefore, the natural rate of unemployment is 0
never zero. The natural rate of unemployment Level of emplyment per period
prevails when the labour market is in
Figure 1: The Natural Level of Employment
equilibrium and the economy is producing
full-employment real output. It’s important to
note that this natural rate of unemployment is the sum of frictional and structural unemployment
(we will cover these concepts later in this sub-unit). In practice, the natural rate of unemployment
is calculated by averaging the unemployment rate over an extended period.

Over time, the natural rate of unemployment can gradually change due to events such as changes
in labour force characteristics, changes in labour market institutions and changes in government
policies such as changes in minimum wages and unemployment policies.

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Changes in structural and frictional unemployment can also affect the natural rate of
unemployment.

The Natural Rate of Unemployment and Full Employment Output

Health Recession Exceptional

Economy expansion

Where is the unemployment rate (u) u = u* u > u* u < u*

relative to the natural rate of the
unemployment (u*)
Where is the economic output (Y) relative Y = Y* Y < Y* Y > Y*
to the full employment output (Y*)

What is the level of cyclical Cyclical Cyclical Cyclical

unemployment unemployment unemployment unemployment
is zero is positive is negative

Changes in Employment Patterns Over Time

The following factors contribute to changing employment patterns:

Employment Sector:
As a country progresses, the workforce in the primary sector typically decreases, with a majority
finding employment in the tertiary sector.

Delayed Workforce Entry:

With more individuals pursuing tertiary education (post-secondary education including
government and private schools and universities, colleges, technical training institutes, and
vocational schools), the average age of employees entering the workforce increases. This trend
is also influenced by a rise in the number of females and mature students in tertiary education,
which can limit the potential size of the economy’s workforce.

Ageing Population:
An increase in the average age of the population, often due to lower birth rates and longer life
spans in developed economies, can lead to a reduced labour supply. This trend encourages firms
to employ older workers and hire individuals beyond their retirement age.

Formal Sector Employment:

Economic development is associated with an increase in the proportion of workers in the formal
economy and a decrease in those in the informal sector. Formal employment involves workers
paying income taxes and contributing to the country’s official GDP.

Female Participation Rates:

As a country develops, a larger proportion of women tend to participate in the labour force. This

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shift is attributed to evolving social attitudes towards women in the economy and choices made by
women in economically developed countries to have fewer children at a later age. These choices
are influenced by the high costs of raising children and the increasing number of women opting to
pursue professional careers.

Public Sector Employment:

As more countries transition towards a market economy with less direct government intervention,
the proportion of people employed in the public sector decreases.

Flexible Working Patterns:

Changes in the global economy necessitate greater flexibility for firms to remain competitive.
Examples of flexible working patterns include hiring more part-time staff, allowing employees to
work from home, introducing flexible working hours, and outsourcing non-core functions (such as
accounting, cleaning, security, and ICT) to other service providers.

Rural and Urban Unemployment Rate Employment across Organised and

Unorganised Sectors

Industry wise Employment Unemployment (in 1%)

Source: Employment and Unemployment Scenario of India, Directorate General of Employment

Think About It
Some scenarios regarding employment and unemployement are given below. Based on
the scenario assigned to your group, discuss the challenges and opportunities faced by the
individual in question. Think about the factors causing frictional unemployment and how
they can be addressed.

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Scenario 1: Recent College Graduate

You are a recent college graduate who has just completed a degree in computer science. You
are eager to start your career in the tech industry, but you are facing challenges in finding the
right job. You have been applying to various entry-level positions at tech companies, but you
are finding it difficult to secure employment due to the competitive nature of the industry
and the specific skill sets that companies are looking for. You are also considering the option
of pursuing further certifications or internships to enhance your qualifications.

Scenario 2: Stay-at-Home Parent Re-entering the Workforce

You are a stay-at-home parent who took a career break to raise your children. Now that your
children are older and more independent, you are eager to re-enter the workforce. However,
you find it challenging to bridge the gap in your resume and demonstrate your current skills
and qualifications to potential employers. You are considering options such as volunteering,
part-time work, or enrolling in refresher courses to update your skills and rebuild your
professional network.

Scenario 3: Construction Worker Transition

You are an experienced carpenter in the construction industry looking to transition
into green construction and renewable energy installations. You are passionate about
sustainability but are facing challenges in acquiring the necessary skills and finding job
opportunities in this specialised sector. You are exploring training programs, seeking
mentorship, and networking to facilitate your transition.

5.2 Causes of Unemployment

Frictional Unemployment
Frictional unemployment, also known as transitional unemployment, arises when workers are
between jobs. This form of unemployment is a result of delays in the labour market, which occur
when a worker moves from one job to another. It’s a natural occurrence in any economy due to the
time it takes for workers and employers to find one another and agree on employment terms.

Suppose Microsoft introduces a new cloud service that becomes extremely popular among Indian
businesses. This leads to a surge in customers, and subsequently, Microsoft needs to hire more
employees to manage the increased workload.

On the other hand, Google experiences a

decrease in customers as they are drawn
towards the new cloud service offered by
Microsoft. This drop in business forces Google
to make some tough decisions, including
laying off some of its employees.

The employees laid off from Google will need some time to find new jobs, and Microsoft will also
need time to decide how many new workers to hire and which applicants to select. This transition
period, where workers are between jobs, results in what is known as frictional unemployment.
Frictional unemployment is usually short-term. If it persists, it becomes structural unemployment.
A few factors affecting frictional unemployment are discussed below:

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1. Immobility of Labour: This is often caused by the geographical and occupational immobility
of labour. Geographical immobility occurs due to factors including family ties, local
friendships, ignorance about job vacancies in other parts of the country, and the cost of
moving. Occupational immobility can result from difficulties in training for jobs that require
different skills, restrictive practices, and discrimination in labour markets.

2. Imperfect Information: In a world of imperfect information, there are incentives for

employees to keep searching for the perfect job and for employers to search longer for the
best employees. Even if there is a perfect job available for every worker, it will still take time
to match workers and jobs. These time lags create friction in the labour market, resulting in
temporary, frictional unemployment.

3. Government Policies: Factors that lengthen the job search process increase frictional
unemployment. These factors include government policies such as unemployment
compensation and government regulations related to the hiring and firing of employees.

Structural Unemployment
In any given economic cycle, certain sectors will experience growth while others may face a
downturn. This fluctuation is a response to evolving consumer demands and shifts in relative
opportunity costs. It’s crucial for the workforce to adapt to these changes, transitioning from
declining sectors to those that are thriving.

For instance, consider the transition from traditional retail to e-commerce. As more consumers
shift to online shopping, traditional brick-and-mortar retail stores may see a decline. Employees in
these stores, such as sales associates or cashiers, may find their roles becoming less relevant.

On the other hand, the e-commerce sector is booming. There’s a growing demand for roles like
web developers, digital marketers, and data analysts. However, a sales associate or cashier from a
traditional retail store can’t immediately transition into these roles without relevant skills.
In this scenario, these workers might face a period of unemployment as they retrain and acquire
new skills, such as coding or digital marketing. This is an example of structural unemployment,
where the skills of workers in declining sectors (traditional retail) don’t match the skills required
in expanding sectors (e-commerce).

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Some workers may face extended unemployment as they retrain for new roles and industries
during their transition period. Moreover, workers nearing the end of their careers might find
retraining unfeasible or struggle to find companies willing to invest in their training for a limited
return period. This type of unemployment, known as structural unemployment, emerges due to
a skills mismatch between workers exiting shrinking sectors and the skills demanded by growing
sectors.

Structural unemployment, which tends to be more persistent than frictional unemployment, can
result from the structural decline of industries that fail to compete or adapt to changing demands,
new products, or the rise of more efficient international competitors. It can also stem from shifts
in skill requirements as industries alter their production methods. In such cases, this type of
unemployment is often referred to as technological unemployment.

Technological unemployment arises from the growth of new industries that employ labour-saving
technologies like automation. Unlike mechanisation, where workers operate machines and overall
labour demand typically increases, automation reduces labour demand when machines (like
robots) operate other machines. Consequently, even as industry output expands, the automation
of production processes can lead to job losses.

Cyclical Unemployment

Cyclical unemployment is a type of unemployment that results from fluctuations in the economy,
specifically the business cycle. Cyclical unemployment is experienced during economic
downturns, i.e., during recessions and slumps.
The output gap can be used to illustrate cyclical
Real GDP

unemployment. In the diagram, the upward- Trend of the

sloping straight line represents the trend real GDP
growth of the economy over time, indicating
a steady increase in Real GDP. The curved red
line below this trend indicates actual levels
B
of real GDP at different times. At point A, the
actual level of real GDP is below this trend A
Cyclical unemployment
line, signifying a negative output gap. This Actual level
scenario is indicative of an economic recession of real GDP
characterised by cyclical unemployment due
to reduced demand for goods and services.
To mitigate this, an increase in demand Time
is essential to boost economic activity. As Figure 2: Unemployment and the Output Gap
demand rises, the economy moves towards
point B, where it aligns with the trend growth, eliminating demand-deficient unemployment and
restoring economic equilibrium.

Cyclical unemployment is also known as Keynesian unemployment and demand-deficient

unemployment. During the Great Depression that began in the U.S. in the 1930s and spread
globally, mass unemployment was evident. During this time, the English economist John
Maynard Keynes believed that deficient aggregate demand was a major cause of persistent mass
unemployment. Free-market economists also agree that a lack of demand in the downswing of
the economic cycle may cause temporary cyclical unemployment. However, Keynes went further,
arguing that the economy could settle into an under-full employment equilibrium caused by a

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continuing lack of effective aggregate demand. In contrast to frictional unemployment, which is

voluntary, Keynes believed that cyclical unemployment is involuntary: that is, not caused by the
workers themselves. As a result, the unemployed should not be blamed for their idleness.
Deficient aggregate
The AD-AS diagram can be used to
Demand
understand cyclical unemployment. Cyclical SRAS1
unemployment is caused by a lack of demand,
SRAS2
which causes a fall in national income
(represented by real national output in Figure
P1
3). The fall in demand causes the AD curve
to shift left from AD1 to AD2. This shift causes
the equilibrium level of national income to P2

Price level
decrease from y1 to y2. Keynesian economists
AD1
argue that if prices and wages are ‘sticky’ (or
inflexible), the economy can remain stuck at AD2
this lower output level.
LRAS
However, free-market economists reject this
view. They assume that markets for both 0
goods and labour are competitive. By reducing Y2 Y1
businesses’ costs of production, falling wages Real National Output
shift the SRAS curve from SRAS1 to SRAS2. The
Figure 3: Cyclical Unemployment Caused by a Leftward
price level falls to P2, and output increases
Shift of Aggregate Demand
from y2 back to the normal capacity level of
output, y1. According to the free-market view, cyclical unemployment is temporary and self-
correcting— provided that markets are sufficiently competitive, and both prices and wages
remain flexible.

Even during healthy economic periods, both structural and frictional unemployment are present.
During recessions, cyclical unemployment appears. At the same time, structural and frictional
unemployment may grow. As a result, the natural rate of unemployment increases. Cyclical
unemployment is the most severe type of unemployment as it can affect every industry in the
economy.
Cyclical

Structural Structural
Natural
unemployment
Frictional Frictional

Unemployment during healthy Unemployment during

macroeconomic conditions recession

Seasonal Unemployment
When casual unemployment results from regular fluctuations in weather conditions or demand,
it is called seasonal unemployment. It is common in trades such as tourism, agriculture, catering,
and building.

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For example, farmers are occupied a lot during the Kharif (June—October) and Rabi (December—
March) seasons and have little work during the off-season. Unless these farmers diversify and take
up some other activities during the off-season, they will be seasonally unemployed. Such off-
seasons arise even for industries based on inputs coming from agriculture, such as sugar, textiles,
tea, coffee, food processing, etc.

Healthy and Unhealthy Unemployment

Unemployment and cholesterol share a commonality in that they both have good and bad types.
Just as there is good and bad cholesterol, there are healthy and unhealthy types of unemployment.
Good cholesterol, like that found in foods such as olive oil, benefits the heart, while bad
cholesterol, found in fried fast foods, poses health risks. Similarly, healthy types of unemployment
contribute to a more dynamic economy, while unhealthy types of unemployment hinder economic
production.

Type of Healthy/ Problem that cause

unemployment Unhealthy needs fixing

Frictional Healthy No Normal, healthy market adjustments

of demand and supply

Structural Healthy Yes Technological change, international

(Worker retraining) competition, resource depletion

Seasonal Healthy No Weather and seasons

Cyclical Unhealthy Yes Business cycles

(fiscal or
monetary policy)

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Check Your Progress 2

1. Look at the newspaper headlines below. For each headline, identify the cause and type of
unemployment it refers to, and the likely impact it will have on the economy.

Type:
Cause:

Impact:

Type:
Cause:

Impact:

Type:
Cause:

Impact:

Type:
Cause:

Impact:

2. When unemployment rises above the natural rate, it reflects the existence of
___________________ unemployment.
a. frictional c. seasonal
b. structural d. cyclical

3. When an economy is operating at full employment:

a. the unemployment rate will equal zero.
b. frictional unemployment will equal zero.
c. cyclical unemployment will equal zero.
d. structural unemployment will equal zero.
e. both (b) and (d) are correct.

4. Badal is a worker in an economy. In each of the following situations, what type of

unemployment does Badal face? Explain your answers.
a. After completing a complex programming project, Badal is laid off. His prospects for
a new job requiring similar skills are good, and he has signed up with a programmer
placement service. He has passed up offers for low-paying jobs.
b. When Badal and his co-workers refused to accept pay cuts, his employer outsourced

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their programming tasks to workers in another country. This phenomenon is occurring

throughout the programming industry.
c. Due to the current slump in investment spending, Badal has been laid off from his
programming job. His employer promises to rehire him when business picks up.

5. If a fall in demand for domestic cars causes auto workers to lose their jobs in Gujarat, while
plenty of jobs are available for plumbers in Tamil Nadu, what kind of unemployment results?

6. The economy is currently in recession, and the following workers are unemployed. Explain
under which type of unemployment their circumstances might be classified.
a. Srija works in the local hotel trade in the summer months on a casual basis but would like
to work all year round.
b. Fazal was made redundant a couple of weeks ago from a furniture store which closed
down. He is currently seeking work in the retail sector.
c. Mouni lives in Maharashtra. Aged 56, she last had a job 12 years ago, working in a local
factory.
d. Pui lost her job six months ago working as a surveyor for an estate agent. She is currently
looking for another surveyor job, but the local housing market is very depressed.
e. Sanchit has been out of work for 18 months. He was the editor of a children’s magazine,
he is seeking a similar job within travelling distance of where he currently lives.

5.2.1 Natural Rate of Unemployment & Potential GDP

When an economy is operating at full capacity, meaning there’s no cyclical unemployment, the
actual output (Real GDP) matches the maximum possible output (Potential GDP). At this point, the
unemployment rate aligns with the natural rate of unemployment, which includes only frictional,
structural, or seasonal unemployment.

Recessionary Gap
A recessionary gap occurs when the economy slows down, causing the real GDP to fall below the
potential GDP. This gap indicates that there are unemployed resources, including labour, resulting
in the real GDP being less than the potential GDP. The rise in unemployment during this period is
cyclical unemployment, which causes the unemployment rate to exceed the natural rate.

Inflationary Gap
An inflationary gap arises when the economy is in an expansion phase, allowing the real GDP to
temporarily exceed the potential GDP. During this period, not only are all resources fully utilised,
but the economy is also operating beyond its normal capacity. The unemployment rate falls
below the natural rate as more workers than usual are employed, reducing the levels of frictional,
structural, or seasonal unemployment. The high demand for labour makes job hunting easier
and quicker. This strong demand might also attract individuals who were previously not part of
the labour force, thereby enhancing the economy’s production capacity. Real GDP can surpass
potential GDP for short durations because the natural unemployment rate at full employment
isn’t zero, but cyclical unemployment is. Full employment still accommodates frictional,
structural, and seasonal unemployment. These types of unemployment, particularly frictional
unemployment, can fall below their usual levels at full employment. As a result, individuals who

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were unemployed due to frictional, structural, or seasonal reasons at potential GDP are now
employed.

Real GDP and Output gap Problem that needs fixing

Potential GDP

Real GDP equals None Natural rate of unemployment - full employment (only
Potential GDP frictional, structural, seasonal employment)

Real GDP below Recessionary Gap Unemployment rate above natural rate (cyclical
Potential GDP employment)

Real GDP above Inflationary Gap Unemployment rate below natural rate (less than
Potential GDP normal, frictional, structural, seasonal unemployment)

Table 1: Natural Rate of Unemployment and Potential GDP

5.2.2 Types of Unemployment

Unemployment is distinguished as:
• Voluntary and Involuntary Unemployment
• Open and Hidden Unemployment

Voluntary and Involuntary Unemployment

Voluntary unemployment refers to the situation where people who are able to work but are not
willing to work at the existing wage rate remain unemployed. This type of unemployment might
arise due to laziness, obsession with wealth and/or leisure. Since this is voluntary, it poses no
serious economic problem.

On the other hand, involuntary unemployment occurs when those who are able and willing to
work at the going wage rate do not get work. Hence, they are unemployed against their wishes.
The paucity of employment opportunities causes involuntary unemployment, and hence, it is an
economic issue. A person who is willing and able to work and is looking for a job but does not find
one is considered to be involuntarily unemployed.

The distinction between voluntary and involuntary unemployment is not always clear-cut, since
the term “voluntary” can be difficult to define. Some people may only want jobs of a specific
type, on certain terms, or in a particular location. If they are unable to find such a job, they may
claim to be involuntarily unemployed. Others may be actively seeking employment but have been
unable to find a job for a long time. In such cases, they may claim to be voluntarily unemployed to
avoid embarrassment. For example, consider an engineer from a fairly prestigious institution who
receives just one job offer after completing their degree. However, this offer provides pay which is
below industry standards and requires them to relocate to a costly city. If this person declines the
offer, are they involuntarily or voluntarily unemployed?

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Open and Hidden Unemployment

Open unemployment occurs when people who are skilled and educated are unable to find work
that can provide them with a regular income to sustain themselves. This situation arises when
the workforce increases at a much faster rate than the number of opportunities available in the
country. Open unemployment can take several forms, including frictional, structural, cyclical,
and/or seasonal unemployment.

Open unemployment can have serious consequences for individuals and the economy as a
whole. When people are unemployed for a long time, they may lose their skills and become less
productive, leading to a decline in the overall productivity of the economy.

Additionally, open unemployment can lead to social unrest and political instability. People
who are victims of open unemployment may resort to criminal practices in order to sustain
themselves, which increases the crime rate in society. Some people also move to work as labourers
in factories or the agricultural sector, which no doubt reduces open unemployment, but causes
disguised unemployment since the full potential of these people is not utilised.

Hidden unemployment can be either disguised unemployment or underemployment. Disguised

unemployment occurs when more people are engaged in a particular work than is necessary for
its efficient completion. For example, a family of farmers owning a small plot of land may all work
on the farm, even if some members' efforts are not actually needed to maintain the current level
of production. This results in hidden unemployment, as the marginal productivity of the surplus
workers is effectively zero.

Another instance of disguised unemployment can be observed in the retail sector in India, where
family members take turns managing the business, leading to some individuals working during
non-peak hours when their labour may not be fully utilised.

Underemployment, on the other hand, refers to a situation where individuals have access to work,
but it is for fewer hours or days than they would like, or the compensation is inadequate. This is
common in developing countries and among marginalised groups.

For instance, a graphic designer working part-time in a studio due to a lack of available full-time
positions would be considered underemployed. Despite having the qualifications and capacity for
a more demanding role, they are unable to find suitable employment matching their skill level,
leading to underutilisation of their abilities and potential.

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Consequences of Unemployment
Unemployment has significant consequences for individuals, firms, and the economy as a whole.
Understanding these consequences is crucial for comprehending the impact of unemployment
on various stakeholders and the overall functioning of an economy. The consequences of
unemployment include:

a. Individuals: Unemployment can lead to stress, depression, low self-esteem, a reduction in

the quality of diet, increased health risk, and even homelessness. The lack of income and
dignity resulting from unemployment can cause severe emotional and psychological distress.
In extreme cases, it can lead to suicides. In India, 9,140 people ended their lives due to
unemployment between 2018 and 2020.

It is important to note that these effects are not limited to the financial well-being of
individuals but also extend to their mental and physical health, as well as their social
relationships and standing within the community.

Think About It
Consider the following scenarios and reflect on the potential impact of unemployment:
Scenario 1: A teenager living with parents who are unemployed.
Scenario 2: An unemployed person in their early thirties with children to support.
Scenario 3: A person in their late fifties who, until recently, has been employed all their life.

a. For each scenario, write a short letter to a national newspaper expressing how you might
feel if you were in that situation. Your letter should address the challenges and emotions
you might face.
b. Compare your views on how you might feel with the views of others in your class. Discuss
the similarities and differences, and consider the reasons behind these differences.
c. Ronald Reagan, former president of the USA, once described unemployment benefits as
“a pre-paid vacation for freeloaders.” How does this statement resonate with the feelings
and challenges you’ve identified in the scenarios above?

b. Family and Friends of the Unemployed: Unemployment has a profound impact on the family
and friends of the unemployed, leading to lower incomes, increased stress, and potential
breakdown of relationships. The financial strain caused by unemployment often results in
arguments, separation, and even divorce within families.

c. Local Community: When a significant number of individuals in a community are without

employment, it can have various detrimental impacts. These include a rise in poverty levels, a
reduction in consumer spending, and a decline in property values due to decreased demand
for housing and real estate. Additionally, the local area may witness an increase in crime rates
as unemployed individuals struggle with financial difficulties. High unemployment rates can
also foster a fear of job displacement by foreign workers, potentially resulting in efforts to
protect domestic jobs and barriers to immigration.

d. Firms: High levels of unemployment have significant implications for firms. With lower levels

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of consumer spending and investment, firms experience reduced profits and face a higher risk
of business failures and bankruptcies during periods of high unemployment. This can lead to
a decline in overall economic activity and a decrease in the competitiveness of the economy on
an international scale. Additionally, firms may find it challenging to attract skilled workers, as
long-term unemployment can lead to deskilling and reduced work readiness among the labour
force.

e. Government: When unemployment rates remain high for prolonged periods, it can have a
significant impact on the government’s financial position, and its ability to provide necessary
support and services to the population. The government has to spend more on welfare benefits
and healthcare for the unemployed, which could lead to increased government expenditure
and debts. Additionally, high unemployment reduces tax revenue for the government in the
form of income tax, further straining its finances.

f. Taxpayers: Taxpayers bear the opportunity costs of unemployment, as increased reliance

on taxpayer funds to finance unemployment and welfare benefits can lead to a loss of
resources that could have been utilised for other purposes. Additionally, as the government
raises less tax revenue due to high unemployment, taxpayers are affected by reduced public
funds available for essential services and infrastructure. Thus, taxpayers bear the burden
of financing unemployment and welfare benefits, while also experiencing the indirect
consequences of reduced government revenue and increased government expenditure.

g. Overall Economy: When workers are unemployed, the economy operates below its potential,
producing inside its production possibility frontier and failing to make the best use of society's
resources. This leads to a reduction in international competitiveness, as high unemployment
diminishes incentives for firms to invest in new technologies and can result in the use of
labour-intensive but antiquated technologies. Furthermore, unemployment contributes
to a widening of income differentials, reduces government tax revenue, increases welfare
expenditure, and leads to lower levels of consumer spending, investment and profits for firms.

Check Your Progress 3

Scan the code and watch this video to answer the questions given below:

1. What are the negative effects of unemployment on individuals?

2. How can unemployment affect the mental and physical health of

individuals?

3. What are the effects of unemployment on families and friends of the

unemployed?

4. What are the effects of high unemployment rates on governments?

5. Can you think of some policy suggestions to alleviate the distress of

unemployed individuals and their families? How can the private
sector help in this context? Would promoting entrepreneurship be
an effective solution?

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Is Unemployment Always Undesirable?

Even though high unemployment can harm the economy, some free-market economists think
that a certain level of unemployment is necessary for the economy to work well. They argue that
unemployment can help lower wages, which in turn can help control inflation. Unemployment
can also lead to bigger differences in income between workers who are paid more and those who
are paid less. Some economists see this as a positive thing. They believe that pay differences are
important because they encourage people to work harder, which helps the economy grow.

Frictional unemployment may bring in positive effects. When workers find jobs that match their
skills better, it can make the production process more efficient. This could even lead to better
allocation of resources in the economy.

5.2.3 Measurement of Unemployment

Unemployment, in its most common definition, refers to a state where individuals are ready
and willing to work but are unable to secure employment. This definition does not account for
disguised unemployment or underemployment, which is characterised by employment with
extremely low productivity and income levels.

In India, the scale of unemployment is much larger than what is typically measured. Individuals
from low-income households cannot afford to remain unemployed and often take up any available
work, even if it provides a very low income. As a result, conventional unemployment rates tend
to be relatively low. It’s important to note that work sharing is prevalent in self-employed and
primary sectors, which are dominant in terms of the labour force in India. Therefore, measures of
open unemployment fall short of accurately capturing the unemployment scenario in India.

Recognising this, the National Sample Survey Organisation (NSSO) in India provides estimates of
unemployment based on three different concepts:

a. Usual Status Unemployment: This concept considers a person as unemployed if they were
not employed but were seeking or available for work for a significant duration during the
reference year. This measure, which reflects chronic unemployment, provides the count of
individuals unemployed over a long period. It is the narrowest concept of unemployment,
yielding the lowest estimate, as very few in a developing country like India can afford to
remain unemployed for extended periods.

b. Current Weekly Status Unemployment: This measure considers a person as unemployed if

they did not work for even an hour during the reference week. It is also a measure of chronic
unemployment but over a shorter reference period. A person would be considered employed
even if they were unemployed for six days of the reference week and worked for an hour
on the seventh day. This measure does not provide the number of unemployed persons, but
rather, measures unutilised time in terms of person weeks.

c. Current Daily Status Unemployment: This concept measures unemployment as the total
person-days of unemployment. It aggregates all the unemployment days of all persons in the
labour force during the reference week. As this estimate includes both chronic unemployment

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and underemployment on a weekly basis, it is the most comprehensive measure. It does not
provide the number of unemployed persons but measures unutilised time in terms of person
days.

5.2.4 Difficulties in Measuring Unemployment

a. Data Collection Methods: The methods used to calculate unemployment rates can vary
significantly, affecting comparability between countries. Some methods include reporting
unemployment claims or conducting surveys. Counting unemployment benefit claims may
underestimate the actual unemployment rate, especially during extended recessions. On
the other hand, survey methods, while often considered more reliable, may overlook certain
populations, such as immigrants or undocumented workers.

b. Employment Measures and Economic Expansion: When businesses increase production, they
may initially avoid hiring new employees until they are certain that the demand for increased
output is sustainable. Instead, they might extend the working hours of part-time employees
or ask full-time staff to work overtime. This doesn’t affect employment figures, as individuals
are classified as “employed” regardless of their working hours. Moreover, economic growth
may encourage previously discouraged workers to restart their job searches, which technically
classifies them as “unemployed,” potentially increasing the unemployment rate.

c. Disparities in Unemployment: The unemployment rate is an average and does not account for
variations across different demographics such as age, gender, socio-economic background and
region. For example, unemployment rates tend to be higher among youth and ethnic minority
groups.

d. Misclassification and Informal Employment: Unemployment statistics may not accurately

reflect the reality due to misclassification and the prevalence of informal employment. For
instance, some individuals might be available for work but have stopped seeking employment
due to the lack of job opportunities in their area. These are discouraged workers. These
individuals are classified as ‘out of the labour force’ despite experiencing the hardships of
unemployment because they are not actively looking for work.
On the other hand, some people may claim to be actively seeking employment but are not
genuinely eager to work. They are counted as unemployed, even though they might be more
accurately classified as ‘out of the labour force.’

Furthermore, there are individuals who are engaged in informal work who do not report their
income to tax authorities. They may report being unemployed when they are, in fact, working.
This informal employment sector can distort the accuracy of unemployment data.

e. Underemployment: This refers to individuals who are employed but are dissatisfied with
their jobs due to factors such as involuntary part-time work or being overqualified for a low-
paying job. Conventional unemployment figures do not capture the level of dissatisfaction and
underutilisation of skills in the workforce.

f. Hidden Unemployment: The reported unemployment rate might be inflated as some

individuals may hide their actual employment status due to fear of losing benefits or because
they are employed in illicit industries.

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g. The quality of employment is unknown: Unemployment figures do not reflect the level of
wages or the working conditions of a country’s labour force. Poor countries with few social
services may have low unemployment rates, yet their workers may experience a high level
of poverty relative to workers in richer economies simply because the alternative is absolute
poverty, or the state of being unable to afford even the basic necessities of life.

Check Your Progress 4

1. Which option is least likely to suggest why it is difficult to compare the unemployment rates of
different countries?
a. Different countries calculate unemployment in different ways
b. The minimum age to work differs in different countries
c. The retirement age varies between countries
d. There is no agreement on the measurement of unemployment

2. The unemployment problem in an economy may be understated by the unemployment rate

due to:
a. people lying about seeking a job
b. discouraged workers
c. job candidates with one offer but waiting for more
d. overemployed workers

3. If unemployment benefits increase and encourage more people to claim that they are looking
for work when in fact, they really are not, then the measured unemployment rate will:
a. rise c. be unaffected
b. fall d. change in an indeterminate direction

4. After looking for a job for more than 8 months, Tinku became frustrated and stopped job-
hunting. Economists view Tinku as:
a. unemployed
b. part of the labour force, but neither employed nor unemployed.
c. a discouraged worker
d. cyclically unemployed
e. both (b) and (c)

5. Why might the fraction of unemployed people who are quitting jobs be higher during a strong
labour demand period?

6. What would happen to the unemployment rate if a substantial group of unemployed people
started going to school full-time? What would happen to the size of the labour force?

7. How might the official unemployment rate understate the “true” degree of unemployment?
How might it overstate it?

8. Since the official unemployment rate misses several types of out-of-work people, is the
measurement of any use to policymakers? Explain your answer.

9. If you know the regional differences in unemployment rates, how can it help you in your job-
search strategy?

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5.3 Inflation
Just as full employment brings about one kind of economic security, an overall stable price level
increases another form of economic security. Without stability in the price level, consumers and
producers will experience more difficulty in coordinating their plans and decisions.

Inflation is a complex economic phenomenon that can be defined in two ways:

a. Inflation is a persistent increase in average prices: This means that over a certain period, the
average price of goods and services rises continuously. For example, an inflation rate of 4%
implies that on average, prices are 4% higher than in the previous period.

However, it’s important to note that not all prices move at the same rate. Some goods may
experience a faster rate of price increase than the average, while others may rise more slowly.
The prices of certain goods may even decrease despite the overall trend of inflation.

b. Inflation as a decrease in the value of money: Inflation reduces the purchasing power of a
given amount of money over time. For example, Rs. 1000 will buy fewer goods and services in
the future than it can today. This happens because as prices rise, the value of money decreases.
Essentially, inflation means your money buys less than before. Inflation can be positive or
negative. Inflation (or positive inflation) is when the average price of goods and services is
rising.

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A general rise in prices can be quite moderate, a condition often referred to as creeping inflation.
Imagine a scenario where prices rise by a small percentage, say 2%, each year. This is generally
not considered problematic. In fact, a low and consistent inflation rate can stimulate production
as firms anticipate a steady rise in prices.

On the other hand, hyperinflation occurs when the rate of inflation becomes extremely high,
causing prices to rise rapidly and the value of money to plummet. This situation can spiral out of
control, leading to a breakdown in the normal use of money and forcing people to resort to barter
systems. In extreme cases, a new currency may need to be introduced to restore stability.

Figure 4: A German woman using paper

money as fuel in her wood-burning stove.
During the 1923–24 hyperinflation in
Germany, it was cheaper to burn paper
money to generate heat for the stove, than
to use the same money to purchase wood for
burning.

Since inflation rates fluctuate up and down,

the term disinflation is used to describe a
reduction in the rate of inflation. Note that
an economy going through disinflation still
experiences rising prices, just at a slower
pace. However, if overall prices in an
economy actually fall, this is referred to as
deflation or negative inflation.

Deflation refers to a sustained decrease in

the overall price level of goods and services
within an economy, resulting in a negative
inflation rate. Deflation can stem from either
demand-related or supply-related factors.

When deflation results from an oversupply of

goods and services, it leads to an expansion
of the economy's productive capacity. This Figure 4
situation, known as benign deflation, can
actually raise national income while lowering the general price level. Factors such as investments
in education and infrastructure, enhanced productivity, better management practices,
technological progress, and government support for key industries can all contribute to benign
deflation by boosting national income in the long term and expanding the economy's capacity,
thereby reducing prices.

Conversely, deflation caused by reduced demand in the economy, leading to a decline in the
general price level due to excess capacity, is known as malign deflation, which poses a threat to
the economy. For instance, during an economic recession, decreased household consumption of
goods and services due to lower GDP per capita and higher unemployment can lead to a drop in
demand, reducing national income and pushing down prices. This type of deflation is concerning
because it is linked to a decrease in national income and living standards.

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5.3.1 Causes of Inflation

When the economy is experiencing inflation and the overall level of prices is rising, we need to
look for an explanation for the same in terms of supply and demand. Inflation can be caused by
two main factors: too much demand in the economy or rising costs. These factors lead to two types
of inflation: demand-pull inflation and cost-push inflation. In a stable and growing economy, with
no demand-side or supply-side shocks, inflation is likely to be caused by a combination of both
demand-pull and cost-push factors.

Demand-Pull Inflation
When the total demand for goods and services in an economy goes up without a corresponding
increase in the supply of goods and services, it can lead to demand-pull inflation. This type of
inflation is driven by an excess of demand in the economy, causing the overall price level to
rise. There are several reasons why excessive increases in aggregate demand can occur in any
economy. These include:

• Large increases in consumer spending, which can happen for various reasons. Low interest
rates often encourage consumers to borrow more money, leading to increased spending
on goods and services. Additionally, an increase in consumer confidence can also result in
substantial increases in consumer spending. When consumers feel positive about their future
income and job prospects, they are more likely to spend money on goods and services.

• Firms may significantly increase their spending on investment, possibly in response to

substantial increases in consumer demand and the need for additional capacity to meet that
demand. Higher business confidence, resulting in increased investment, can also contribute
to a rise in aggregate demand.

• The government might be substantially increasing its spending or cutting taxes, both of which
can lead to higher aggregate demand.

• Increased world demand for a country's exports due to a global economic boom can also
contribute to demand-pull inflation.

Demand-pull inflation can also be caused by

the growth of the money supply. Both central
banks and the banking system can influence
the amount of borrowing and lending in the
economy. If banks increase their lending to
customers, the money supply will expand, SRAS
Price level

leading customers to spend the money they

P2
have borrowed, thereby increasing aggregate
P1
demand and potentially causing inflation. AD2
AD1
The diagram below illustrates how an increase
in aggregate demand in the short run results in
0
inflation. Aggregate demand rises from AD1 to Real Output
AD2, and the price level increases from P1 to P2, Figure 5: Demand-pull Inflation
demonstrating the inflationary impact of this
increase in aggregate demand.

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Think About It
In the feudal system of medieval Europe, lords and vassals engaged in an economic
relationship where peasants paid taxes to the lords in the form of a portion of their harvest.
As the use of coins became more prevalent, peasants began paying their taxes with gold
coins.

Some lords, seeking to increase their wealth without overtly raising taxes, engaged in a
practice known as coin clipping. This involved shaving off small amounts of gold from the
edges of coins and using the clippings to mint new coins, effectively increasing the money
supply. This led to inflation, as the increased money supply exceeded the available goods,
causing prices to rise. Consequently, the purchasing power of each gold coin earned by
the peasants decreased, effectively transferring wealth from the peasants to the lords.
This practice of coin clipping can be seen as a form of hidden taxation, as it reduced the
purchasing power of the existing currency, effectively taking wealth from the peasants.

Figure : Comparison of Unclipped and Clipped Siliqua (Roman Silver Coins)

In more recent history, some dictators have resorted

to simply printing more money to enrich themselves
and their loyalists, resulting in similar inflationary
consequences. It leads to a situation where the
population experiences a reduction in their real wealth
without a direct increase in explicit taxes, the net
result of which works similar to a hidden tax.

This illustrates how people in control of the

money supply can benefit from inflation at the
expense of the general population. Therefore,
it is important for a society that values stable
prices to be cautious about entrusting the
control of its money supply to individuals who
stand to gain from inflation.

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Questions
1. Why might a government with a huge foreign debt be tempted to increase its domestic
money supply and cause inflation?

2. In what ways can the concept of hidden taxation through inflation be observed in
contemporary economic systems or government policies?

3. Considering the impact of inflation on wealth distribution highlighted in the passages,

how might similar dynamics be at play in today's global economy? What implications
does this have for economic inequality?

Cost-Push Inflation

Inflation can occur due to changes in the supply side of the economy. Increases in costs of
production can cause cost-push inflation. There are four primary sources of increased costs that
can contribute to cost-push inflation:

a. Wages and Salaries: An increase in wages and salaries can significantly impact the costs of
production, as labour expenses typically represent a substantial portion of total production
costs. When wages and salaries rise, businesses may face higher costs, which can lead to
upward pressure on prices.

b. Profits: Firms may seek to enhance their profits by raising prices to improve profit margins.
The degree to which they can do so depends on the price elasticity of demand for their goods.
In cases where demand is relatively inelastic, firms may have more leeway to raise prices
without experiencing a significant decline in demand.

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c. Government: Government actions, such as raising indirect tax rates or reducing subsidies,
can contribute to cost-push inflation by increasing costs for businesses. As a result, firms may
attempt to pass on these cost increases to consumers through higher prices.

d. Imports: A surge in global economic activity can drive up commodity prices, such as those
of oil, copper, and wheat. This, in turn, can result in higher import prices for an economy,
ultimately leading to increased prices of finished goods.

When firms face rising costs, they often seek to pass on these cost increases to customers by
raising prices. For example, if a firm grants a 5% pay increase to its employees, and labour costs
account for 60% of its total costs, the firm may need to raise prices by 3% (60% of 5%) to maintain
its profit margins. However, competitive pressures in the market may limit the firm's ability to pass
on these cost increases while maintaining sales levels. Over time, as costs continue to rise, firms
may find it necessary to raise prices, contributing to inflation.
SRAS2
The adjoining figure illustrates how a decrease
in short-run aggregate supply can lead to P2 SRAS1
inflation. The SRAS curve shifts upward Price level
P1
from SRAS1 to SRAS2, driven by factors such
as rising wage rates or import prices. As a
result, the price level increases from P1 to P2,
AD
demonstrating the inflationary impact of the
increase in SRAS. 0
Real Output
Figure 6: Cost-push Inflation

Check Your Progress 5

Read each scenario and guess if it is caused by demand-pull inflation or cost-push inflation.

1. A country experiences a sudden increase in consumer spending due to a successful

government stimulus program that puts more money in the hands of consumers.

2. The government imposes new regulations that significantly increase the cost of production for
a specific industry, leading to higher prices for its products.

3. A technological breakthrough leads to a surge in consumer demand for a specific type of

electronic device, causing prices to rise rapidly.

4. A booming global economy results in a significant increase in demand for a country's exports,
leading to higher prices for those goods in the domestic market.

5. A sudden increase in oil prices on the global market leads to higher transportation and
production costs for businesses, resulting in price hikes for various goods and services.

Check Your Progress 6

1. Headline inflation takes into account price changes in food and energy, but these prices are

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known to fluctuate significantly. Economists often exclude these changes to better understand
the overall trend in inflation over time, known as the underlying inflation rate.

In March 2017, the OECD reported that most countries were experiencing an increase in
headline inflation due to higher energy prices, which was influenced by OPEC's decision to
reduce oil production in November. The OECD noted that the underlying inflation rate in
advanced economies was still low at that time, but it was expected to rise gradually as global
economic growth improved.

a. Using AD-AS analysis, explain the effect of a rise in energy prices on headline inflation.
b. Using AD-AS analysis, explain the likely effect of an increase in global growth on the
inflation rate for advanced economies.
c. Provide a graphical representation of your reasoning. Ensure your explanations clearly
distinguish between demand-pull and cost-push inflation.

2. Under Article IV of the International Monetary Fund’s (IMF’s) Articles of Agreement, the IMF
holds bilateral discussions with members, usually every year. In the context of the 2016 Article
IV mandated consultation with India, the IMF published a report on India's economy in March
2016. It stated that India's headline consumer price inflation had declined from an average
of 10 per cent during the period 2009-13, to 5.6 per cent in December 2015. This reflected
'economic slack, an appropriately tight monetary policy stance by the Reserve Bank of India
and lower global commodity prices.'

You can refer to the report here:

https://www.imf.org/external/pubs/ft/scr/2016/cr1675.pdf

a. Using the AD-AS analysis, explain the causes of the fall in India's consumer price inflation
over this period.
b. Explain two likely problems for the Indian economy of a high inflation rate over the
period 2009-13.

5.3.2 Consequences of Inflation

Redistributional Costs
Inflation, the general increase in prices of goods and services, can have significant effects on the
distribution of income and wealth among households, firms, and the state. This redistribution
occurs in various ways, impacting different groups of people:

• Lenders: Whether individuals, firms, or governments, tend to lose from inflation. This is
because the money they have lent out becomes worth less due to inflation, leading to a
decrease in the real value of the money they receive back from borrowers.|

• Savers: Inflation can have a significant impact on individuals, businesses, and governments
who save money. When the rate of inflation exceeds the interest rates for savings, the real
value of saved money decreases. When inflation surpasses savings interest rates, the real
value of saved money decreases. For example, if inflation is 3% and savings interest rates are
2%, the real interest rate becomes -1%, discouraging saving. This disincentive to save leads to

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fewer funds for investment in the economy. With reduced savings, there are fewer resources
for businesses to borrow and invest in growth and innovation, potentially hindering economic
development.

• Fixed-income Earners: Fixed-income earners, such as salaried workers and pensioners whose
income does not change with the level of output, experience a decrease in their real income
during periods of inflation. This means that their purchasing power declines as prices rise.
Even if these individuals receive a pay rise, the rate of inflation reduces the real value of this
increase.

• Borrowers: Borrowers generally benefit from inflation. When they repay their loans, the
money they need to pay back is worth less than when they initially borrowed it. This results in
a decline in the real value of their debt due to inflation.

The relationship between inflation and the interest rate affects the redistribution of income
and wealth. If the rate of interest does not rise in line with inflation, borrowers benefit as they
pay back less in real terms, while lenders lose out as they receive less in real value. Suppose a
borrower takes out a loan at a fixed interest rate of 5%. If inflation is running at 3.5%, the real
interest rate (the nominal interest rate minus the inflation rate) is only 1.5%. This means that the
borrower effectively pays back the loan at a lower real cost due to inflation. On the other hand, the
lender receiving the repayments effectively receives less in real value, because the money they
lent out is worth less due to inflation.

Growth and Unemployment

When inflation is high and unpredictable, it becomes challenging for both consumers and
businesses to foresee future inflation rates. This uncertainty makes it tough for them to make
plans for the future. For example, businesses may become hesitant to invest in new projects due
to the risks associated with an unstable economic environment. Similarly, consumers may change
their spending habits based on their predictions of future inflation, which can disrupt the overall
spending patterns in the economy.

This disruption in economic activity can lead to lower levels of output and spending than what
would normally occur. As a result, the economy may experience reduced growth or even a decline
in GDP, which can then lead to higher unemployment rates.

Menu Costs
Inflation affects the prices charged by businesses, necessitating regular updates to catalogues,
price lists, and menus. This incurs significant costs for businesses, as they must also compensate
workers for the time spent repricing goods and services. Menu costs refer to the expenses
incurred by businesses when they adjust their prices.

For instance, in the restaurant business, inflation requires changes to menus to reflect increased
prices. Similarly, retail shops must update their price labels, and firms need to issue new price
lists. Additionally, adjusting fixed capital, such as vending machines and parking meters, to
accommodate price increases can be particularly costly.

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Shoe-leather costs
Shoe-leather costs refer to the expenses incurred when individuals and businesses move their
money between different banks or financial institutions in order to find the best interest rates.
When prices are stable, people generally have a good idea of what a fair price for a product is and
which suppliers offer the best deals. However, when prices are rising, it becomes more difficult to
determine what a reasonable price is. As a result, people end up spending more time and effort
"shopping around" for the best deals, which in turn leads to additional costs, akin to wearing out
one's shoes from all the walking. This extra effort and time spent searching for the best deals is
what economists refer to as shoe-leather costs.

International Competitiveness
Inflation can make a country's products more expensive compared to products from other
countries. This can lead to a decrease in the demand for the country's exports and an increase
in the demand for imports. As a result, the country may spend more on importing goods and
earn less from exporting its own products. This imbalance in trade can lead to difficulties in the
country's balance of payments, which measures all the financial transactions between the country
and the rest of the world.

Money Illusion
Money illusion, also known as “inflationary noise," occurs when inflation distorts the perception
of prices for consumers and businesses. When prices rise due to inflation, it can be challenging
to accurately assess the true changes in relative prices. This can lead to misconceptions about the
actual cost of goods and services.

For instance, a product's price increase may not necessarily mean that it has become more
expensive compared to other products. In fact, the price of the product may have risen
by a smaller percentage than the overall inflation rate, making it relatively cheaper. This
misunderstanding of price signals can lead to incorrect decisions by consumers and businesses.

Another example is a business mistakenly interpreting the rising prices of its products as a signal
to increase production, assuming that the higher prices reflect increased demand. However, in
reality, the price increase may be solely due to inflation, leading to a misallocation of resources.

Even when individuals are aware of inflation, they may not always react rationally. This can
stem from money illusion, wherein people perceive nominal changes in wages or prices as real
changes. For example, if the price of a movie ticket increases by 10%, but wages and other prices
also rise by a similar amount, the real cost of the movie ticket remains unchanged. However, many
individuals mistakenly believe that movies have become more expensive and may adjust their
behaviour based on this perceived price increase.

Inflation Causing Inflation

nflation, which is a general increase in prices, can create a cycle that perpetuates further inflation.
When people anticipate that prices will continue to rise, they adjust their behaviour in ways that
actually contribute to inflation.

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For instance, workers expecting the cost of living to increase may demand higher wages. In
response, firms facing higher labour costs may raise prices on their products to maintain their
profit margins. This, in turn, leads consumers to buy goods and services sooner rather than later,
fearing that prices will only continue to climb. This cycle of expectations and reactions can fuel
inflation, as each group's actions reinforce the others' beliefs about rising prices.

Fiscal Drag
Fiscal drag, also known as "bracket creep," is a phenomenon that occurs when the income levels
at which different tax rates apply are not adjusted to account for inflation. This means that as
people's incomes rise with inflation, they may find themselves pushed into higher tax brackets,
leading to an increase in the amount of tax they have to pay.

To put it simply, imagine you start off in a lower tax bracket because your income is relatively
low. Over time, as your income increases due to inflation, you might find yourself earning more
but also paying a higher percentage of your income in taxes because you've crossed into a higher
tax bracket. This can feel like you're being "dragged" into paying more taxes even though your
purchasing power hasn't necessarily increased by the same amount.

Some argue that this is a consequence of an inefficient tax system rather than a direct result of
inflation. In other words, it's not inflation itself that's causing the problem, but rather the failure to
adjust tax brackets to keep pace with inflation.

Psychological and Political Costs

Inflation can have significant effects on both the psychology of individuals and the political
landscape of a society. When prices rise, people often feel that they are worse off, even if their
incomes also increase. This can lead to dissatisfaction and a sense of financial strain among
the population. Moreover, high rates of inflation can disrupt the distribution of income and
wealth within a society. This means that even if people's incomes are rising, the increased cost
of goods and services may disproportionately affect certain groups, leading to social unrest and
dissatisfaction.

Unexpected inflation can have profound effects on the existing social order. History shows that
periods of high inflation have often been accompanied by social change and even revolution.

Check Your Progress 7

1. Suppose you took out Rs. 2,00,000 in student loans at a fixed interest rate of 5%. Assume that
after you graduate, inflation rises significantly as you are paying back your loans. Does this rise
in inflation benefit you in paying back your student loans? Explain your answer.

2. In 2019, India's consumer price index rose by 4.1 per cent, and in 2020, it rose by 6.2 per cent.
How might the following have been affected in real terms by the change?
a. A retired individual living on a fixed pension income.
b. A person with savings in a fixed deposit account, given that the interest rate on a fixed
deposit was 5.5 per cent in 2019 and 4.8 per cent in 2020.

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c. An individual whose income tax exemption limit was ₹2,50,000 between April 2019 and
March 2020 and ₹3,00,000 between April 2020 and March 2021.

3. You have been informed that due to your outstanding academic performance, you will receive
a 3% increase in your scholarship for the next academic year. However, it's important to
consider the impact of inflation on your purchasing power. If the inflation rate is 4% per
year, then you would need a 4% increase in your scholarship just to maintain your current
purchasing power. Look up inflation rates based on the CPI and answer the following
questions:
a. Calculate how much your scholarship would need to increase to keep up with the inflation
rate. Explain the significance of this calculation in terms of maintaining your standard of
living and purchasing power.
b. In what situation would a 3% raise signify a lower real income?
c. What inflation problem must you overcome to correctly see the value of the raise?

Striking the Balance: Understanding India's Inflation Targets

Inflation targeting is a monetary policy approach used by central banks to manage the annual
rate of inflation. It is designed to bring stability, predictability, and transparency to the decision-
making process regarding monetary policy. There are two main forms of inflation targeting: strict
and flexible. Strict inflation targeting focuses solely on keeping inflation as close to a specific
target as possible, while flexible inflation targeting takes into account other factors such as interest
rates, exchange rates, output, and employment.

In 2016, the Indian Parliament made amendments to the RBI Act of 1934, introducing an inflation-
targeting framework and altering the country's monetary policy. Under this framework, the
central government, in consultation with the RBI, establishes an inflation target and upper and
lower tolerance levels for retail inflation every five years. The current inflation target is set at 4%,
with an upper tolerance limit of 6% and a lower tolerance limit of 2%. These limits indicate that
while the ideal inflation rate is close to 4%, some deviation is acceptable. The targets and bands
are reviewed every five years, and in March 2021, the existing targets were retained.

5.3.3 Measuring the Inflation Rate

The Consumer Price Index (CPI) is an important tool used to measure changes in the cost of living
and the value of money. It helps us understand how prices for goods and services change over
time, and how these changes impact the purchasing power of consumers.

To calculate the inflation rate, we use the following formula:

CPIx+1 - CPIx
Rate of Inflation =
CPIx

where CPIx is Consumer Price Index of the initial year, and CPIx+1 is Consumer Price Index of the
next year.

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For example, if the CPI in June 2018 was 125.9 and the CPI a year earlier in June 2017 was 123. The
inflation rate is calculated as:
125.9 - 123
Rate of Inflation = X 100 = 2.4%
123

5.3.4 Distinguishing High Inflation from

a High Price Level
In the figure provided, we can see the
relationship between the CPI and the inflation
rate in a hypothetical economy from 1970
to 2010. The figure is divided into two parts,
emphasising the difference between high
inflation and high prices.

When the price level (as shown in part (a) of

the figure) rises rapidly, particularly from 1970
through 1982, the inflation rate (as shown in
part (b) of the figure) is high. This means that
prices are increasing at a fast pace during this
period.

Conversely, when the price level rises slowly,

especially after 1982, the inflation rate is low.
This indicates that prices are still increasing
but at a slower rate compared to the earlier
period.

When the price level falls, as seen in 2009, the

inflation rate becomes negative. This situation
is known as deflation. This means that prices
are actually decreasing, leading to a period of
falling prices.

Therefore we can see that a high inflation rate

means that the price level is rising rapidly,
while a high price level means that there has
been a sustained period of rising prices.
Figure 7: The CPI and the Inflation Rate

5.3.5 What the Inflation Rate Misses

There are challenges in using the CPI to measure inflation (or deflation). Some of the major
challenges are detailed below:

• Standard of Living vs Cost of Living: The CPI helps us isolate the impact of changing prices
by keeping the quantities of products and services constant from year to year. However, in the

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real world, as prices change, consumers change the quantities of products and services they
buy. They also eagerly buy new and improved versions of products and services. These trends
are not fully captured by the inflation rate, which focuses solely on changes in prices.

• Switch to Cheaper Substitutes: The CPI does not account for the fact that people may switch
to cheaper substitutes when prices rise. This means that the CPI may overstate increases in
the cost of living because it does not consider the cost-saving behaviour of consumers. For
example, when the price of gasoline rises, people may choose to drive less and use public
transportation instead.

• New and Better Products: The CPI suffers from an inability to account for the introduction
of new products and changes in the quality of existing products. Imagine a year when new
and exciting products like the iPhone or tablet computers are introduced. These products can
significantly impact people's lives and how they spend their money. However, the CPI basket
doesn't easily reflect these changes. This means that it's challenging to compare the cost of
living in a year when these new products exist to an earlier year when they didn't.

Furthermore, many businesses continuously improve the quality of their products or services
while keeping the prices constant. For example, a company might introduce a product at a
certain price and then regularly upgrade its features without increasing the price. This means
that consumers are getting more value for the same amount of money. However, the CPI doesn't
fully capture these improvements in product quality. For instance, a company like Apple might
introduce a product like the MacBook Air at a certain price and then regularly enhance its
features, such as a faster processor, a bigger hard drive, or more RAM, all without raising the
price. Since the CPI basket doesn't change to reflect these quality improvements, it can overstate
increases in the cost of living.

Check Your Progress 8

1. The following table indicates the percentage change in the price level in different years in a
low-income country.
Domestic prices (% change over 10-year periods)

1985 1995 2005 2015

63.8 330.0 40.5 20.4

Over the entire period covered by the data, which of the following can be deduced?
a. There was a fall in the cost of living in the country throughout the data period.
b. The annual rate of inflation fell in 2015.
c. Between 1995 and 2015, a fall in the 10-year rate of inflation took place.

2. Calculate the price index if there is 3.0 % inflation during the year if the index was previously
at 130.

3. Calculate the cost of a basket of goods and services which is currently priced at Rs.2000, if the
CPI increased from 125 to 135.

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4. Deflation lowers the cost of living. Why, then, do economists consider it worse than low
inflation for the economy in general and for you in particular?

5. Using the information about prices listed below, calculate a price index for 2015, 2016, and
2017. Let the market basket consist of one pizza, two sodas, and three caffe lattes. Let the year
2015 be the base year (with an index value of 100).

Year Price of a Pizza Price of a Soda Price of a Caffe latte

2015 $9.00 $0.50 $2.00

2016 $9.50 $0.53 $2.24

2017 $10.00 $0.65 $2.90

How much inflation occurred between 2015 and 2016? Between 2015 and 2017?

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