RESEARCH METHODOLOGY CIA 2

THE PHILLIPS CURVE- INFLATION AND UNEMPLOYMENT

TEJASWINI KATE ROLL NO 61 TYBA

INDEX

1. Introduction 2. Objective 3. Literature Review 4. Data and Methodology 5. Analysis 6. Policy implications and recommendations 7. Conclusion 8. Bibliography

Introduction: The short run relationship between real growth and inflation, which is referred to as Phillips curve (Phillips, 1958) has been the subject of many studies. The rationale behind Phillips curve is that as aggregate demand increases, it causes an increase in demand for factors of production, especially labour force pushing wages and employment upward. As wages rise, cost of production rises, leading to higher cost of living. In the long run, the economy returns to its long run output and its natural rate of unemployment. For this reason, Phillips curve has been estimated as the short run relationship between unemployment rate and inflation rate. As the former decreases, the latter increases. The baseline unemployment rate is known as the non-accelerating inflation rate of unemployment (the NAIRU), and modern specifications based on it are known as NAIRU Phillips curves. NAIRU Phillips curves are widely used to produce inflation forecasts, both in the academic literature on inflation forecasting and in policymaking institution. This wide use is based on the view that inflation forecasts made with these equations are more accurate than forecasts made with other methods. For example, Blinder, the former Vice Chairman at the Board of Governors of the Federal Reserve System, argues that "the empirical Phillips curve has worked amazingly well for decades" and concludes, on the basis of this empirical success, that a Phillips curve should have "a prominent place in the core model" used for macroeconomic policymaking purposes. Non-inflationary growth has been a major objective of economic planning in India, more so since it was first explicitly stated in the fourth five-year plan (1969-73). In fact, the 1970s saw the emergence of high inflation the world over, and there was a renewed interest in the monetary policy and the role of the central banks in ensuring price stability. In 1991, the Maastricht Treaty marked the consensus of the advanced countries on price stability being the main objective of their central banks. The case of developing countries, including India, has been somewhat different in as much as the central banks have been viewed as responsible not only for price stability but also as facilitators of economic growth. In retrospect, it seems that it has been a job well performed. However, in view of the recent price rise, concerns are being expressed as to why inflation in India is so high. And why is it, that in the case of India, stabilising inflation does not lead to stability in the output gap? Why cant the Reserve Bank of India (RBI) focus on the single objective of inflation control? To answer these questions, we need to know the empirical relationship between inflation and the output gap - in other words, the Phillips curve. Older Keynesians define the output gap as arising primarily due to inflationary pressures, though the New Keynesian Dynamic Stochastic General Equilibrium theory posits that the output gap arises primarily due to nominal rigidities. In the words of Milton Friedman, There is always a temporary trade-off between inflation and unemployment; there is no permanent trade off. The temporary trade off comes not from inflation per se, but from unanticipated inflation, which generally means, from a rising rate of inflation.

Objective: The paper proffers the concept of extended Phillips curve, designed to capture the effect of changes in the unemployment rate over time. The reasoning is that inflation depends not just on the expected inflation rate and the level of unemployment, but also on the change in the unemployment rate going forward, as sharp reduction in the jobless rate means rising level of wages immediately, which in turn can well show up as higher inflation. Besides, in a fast-growing economy undergoing structural change, the finding is that the parameter tracking change in unemployment is negative, implying falling unemployment at any given time in relative terms. So the suggestion is that proactive policy strategy to reduce involuntary unemployment or shore up overall growth is 'not likely to generate inflationary pressures in India.' It is because of the structural complexities, of the need to take into account employment in rural areas, agriculture, and informal sectors, which the quin-quennial national sample surveys are undertaken to capture the multidimensional nature of the labour market. The paper observes that the policy problem is to reduce unemployment and at the same time to bring down the domestic inflation rate. So the set of policy choices is either to aim at fast recovery of output and employment or to chalk out a more gradualist dis-inflationary policy. It is also noted that reliable long-term time series data on unemployment rates are simply not available in India. So the game plan is to use alternative formulations to proxy unemployment over time. One practice is to substitute change in joblessness by output. And it has been empirically shown that deviation of output from the trend rate is inversely related to deviations of unemployment from its natural rate, termed Okun's Law. The paper goes on to construct a time series of inflationary expectations and output, taking into account current and past inflation rates, using regression equations. Now one of the problems in formulating and testing the expectations hypothesis is that no direct price expectations data are available for most developing countries.

Literature Review: It is easy to trace the money in its progress through the whole commonwealth; where we shall find that it must first quicken the diligence of every individual, before it increases the price of labour. David Hume thus posit more than two and a half centuries ago when explaining consequences of increases in money supply with respect to unemployment and inflation. Blanchard and Katz (1996) cite a 1991 study done by Lawrence Ball where Ball presented evidence that those OECD countries which experienced larger or longer disinflations in the 1980s, especially those with both large disinflation and generous unemployment benefits, have also experience larger increases in the natural rate of unemployment from 1980 to 1990 (Blanchard & Katz, 1996, p.27). Lansing (2002) concludes that although the inverse relationship between unemployment and inflation in the short-run remains true, the magnitude of the trade-off is not static over time. In addition, the curve may shift inward or outward. Thus, the relationship has to be reestimated periodically if one wants to use the Phillips curve in forecasting inflation. Nonetheless, he acknowledges in the same study the research done by Fisher, et al. (2002) which shows that the Phillips curve model forecasts the actual direction of changes of future inflation 6 to 7 times out of 10. Economists soon estimated Phillips curves for most developed economies. Most related general price inflation, rather than wage inflation, to unemployment. Of course, the prices a company charges are closely connected to the wages it pays. The close fit between the estimated curve and the data encouraged many economists, following the lead of Paul Samuelson and Robert Solow, to treat the Phillips curve as a sort of menu of policy options. For example, with an unemployment rate of 6 percent, the government might stimulate the economy to lower unemployment to 5 percent. But if the government initially faced lower rates of unemployment, the costs would be considerably higher: a reduction in unemployment from 5 to 4 percent would imply more than twice as big an increase in the rate of inflation about one and a quarter percentage points. A number of studies have inferred the inflation forecasting power and advantage of the Phillips curve (see Mio (2001), Blinder (1997), and Stock and Watson (1999), Fisher et al. (2002)). More importantly, studies show that the price Phillips curve tracks inflation path turning points, and, consequently, monetary policy direction quite well. Although economists concluded there wasnt a long-run tradeoff between inflation and unemployment, they still believed in a short-run effect. From 1979 to 2003, Fed Chairman Paul Volcker and his successor, Alan Greenspan, exploited this method by periodically raising interest rates(the fee paid on borrowed money) to push unemployment higher to achieve lower inflation.

Data and Methodology: (A) Establishing the relationship between unemployment and inflation for the years 20022011, and conducting a regression and correlation analysis. Unemployment Inflation Years Rate Rate 5.4 2002 8.8 3.8 2003 9.5 4.2 2004 9.2 4.2 2005 8.9 5.3 2006 7.8 6.4 2007 7.2 8.3 2008 6.8 10.9 2009 10.7 11.7 2010 10.8 8.9 2011 9.8

Data Source: RBI( Handbook of Indian Statistics) The above graph shows that the Phillips curve that portrays a negative empirical relationship between inflation and the unemployment rate , does not hold good stead with respect to India. From the above statistical analysis, it can be seen that while initially for the years 2002-2003, with a rise in the unemployment rate, the inflation rate falls, but in the preceeding years it does not demonstrate the same negative relationship and fluctuates from being a positive to a negative relationship.

(B) Using the Online Application from the Chapter Labour Market from the book D Souza, Errol. Macroeconomics (2008).

Years Unemployment Inflation 1972-73 1.6 11.1 1977-1978 2.6 5.1 1982-1983 1.9 4.3 1987-1988 2.7 8.2 1993-1994 1.9 8 1999-2000 2.8 3.1 2004-2005 3.1 6.8

Source: NSSO,Central Statistical Organisation,India and RBI( Handbook of Indian Statistics) In this scatter diagram, it can be noticed that when unemployment increased between 1982-1983 and 1987-1988, and again between 1999-2000 and 2004-2005, inflation increased rather than decreased contrary to what a Phillips curve would predict. To examine why inflation increases have been accompanied by unemployment increases in the recent past, the government economic survey for the year 2005-2006 was studied. According to this survey, Average headline world price of Indian basket of crude petroleum increased by 47.9 per cent from US $ 36.3 per barrel in April-September
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2004 to US $ 53.7 per barrel in April-September 2005. The downward secular trend in inflation observed since the beginning of reforms in 1991 came under threat with this rapid rise in international price of crude and petroleum products. The prices of petroleum products (diesel and motor spirit) were revised twice on June 20 and September 6, 2005, but the timings and extent of the revisions as well as fiscal intervention ensured that the large increases in the world price of crude and petroleum products were only partially passed through to the consumers and the rest of the economy

Analysis: For a while, the trade-off between inflation and unemployment, captured in the Phillips Curve, was taken as one of the key facts of monetary economics. Stagflation in the 1970s posed a significant challenge to belief in the relationship, but modifications, including postulation of a natural rate of unemployment, gave rise to the idea of a short-term versus long-term Phillips Curve. Essentially, higher inflation could reduce unemployment in the short term, but attempts to hold unemployment below its natural rate would lead to increased joblessness and higher inflation over the longer term. If a government persists in attempting to maintain unemployment below the natural rate, the policy is no longer random and is anticipated. In that case; there will be no effect of policy on the economy. Thus, when expectations are rational, government policy is ineffective in its attempts to stimulate the economy, when prices and wages adjust quickly to equate the supply and demand and supply of labour. This has been labelled as the Policy Ineffectiveness Proposition This states that the government cannot systematically exploit the Phillips curve to guide the economy to a point on it. This is because with rational agents the policy will come to be anticipated and workers will seek to protect their real wages, with no consequent effect on employment and output.

Policy Implications & Recommendations: The post-financial crisis period saw the government under immense pressure to tackle the inflationary situation while simultaneously facing the challenge of boosting the economy. The government could not progress on either front. This can be attributed to a possible misreading of the situation because of infirmities in the data used to arrive at policy decisions. There are three major areas in which data infirmities are reflected. (1) There is a discrepancy in inflation as reflected in the WPI and CPI. The RBI should discontinue using WPI as a measure of inflation; a better way forward would be to replace WPI with Producers Prices Index (PPI), which captures prices of both goods and services and is more representative for supply side management. For monetary policymaking, which is essentially demand management, global experience suggests that countries use mostly CPI. It captures the agents expectation and demand channel. (2) The second problem is the use of IIP as a proxy to measure overall economic activity. Even though IIP captures only 16 per cent of the contribution to total GDP, it has been frequently used in macro modelling merely because IIP
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data is available on a monthly basis. (3) Quarterly estimates of GDP, particularly in the postcrisis period, have proved unreliable. This data has been revised a number of times in the post-crisis period. Strengthening the statistical capacity to ensure more reliable estimates of quarterly GDP data will help improve policy formulation. The consensus in recent literature is that stabilisation of the output gap helps lower inflation and hence, should be the major macroeconomic policy objective. However, the output gap is an unknown variable.There is still inadequate research on the estimation of the output gap in the Indian context. Further research on this will help calibrate policymaking more accurately. Inflation in the post-financial crisis period was created by both supply and demand shocks. The inability to co-ordinate fiscal and monetary policies resulted in the failure of demand management. On the fiscal side, political constraints imposed by looming elections impeded fiscal consolidation while the tiny incremental steps towards monetary tightening by the RBI failed to have an impact on demand. There was a failure to tackle the supply shocks as well. Monetary policy can be used effectively to dampen the effects of a supply side shock. Economic literature suggests that countries learn from earlier supply side shocks. Clearly, therefore, estimating the contribution of supply shocks to inflation will prove a useful instrument in policymaking.

Conclusion: Many articles in the conservative business press criticize the Phillips curve because they believe it both implies that growth causes inflation and repudiates the theory that excess growth of money is inflations true cause. But it does no such thing. One can believe in the Phillips curve and still understand that increased growth, all other things equal, will reduce inflation. The misplaced criticism of the Phillips curve is ironic since Milton Friedman, one of the co-inventors of its expectations-augmented version, is also the foremost defender of the view that inflation is always, and everywhere, a monetary phenomenon. The Phillips curve was hailed in the 1960s as providing an account of the inflation process hitherto missing from the conventional macroeconomic model. After four decades, the Phillips curve, as transformed by the natural-rate hypothesis into its expectations-augmented version, remains the key to relating unemployment (of capital as well as labour) to inflation in mainstream macroeconomic analysis.

Bibliography: Ball, L. (1998),Policy rules for open economies, Working Paper No. 6760, National Bureau of Economic Research, Cambridge, January. Basu, K. (2011b),Understanding inflation and controlling it, Economic and Political Weekly, Vol. 46 No. 41, pp. 50-64. Blanchard,O & Katz,L.F(1996) What We Know and Do Not Know About the Natural Rate of Unemployment NBER Working Paper No. 5822 Blinder, A.S. (1997), Is There a Core of Practical Macroeconomics that We Should All Believe? American Economic Review, 87 (2), pp.240-243. Dua, P & Gaur, (2009) Determination of Inflation in an Open Economy Phillips Curve Framework: The Case of Developed and Developing Asian Countries Centre for Development Economics, Delhi School of Economics, Working Paper No. 178 DSouza,E(2008) Macroeconomics Pearson education Fisher, J.D.M., C.T. Liu, and R. Zhou (2002), "When Can We Forecast Inflation?" FRB Chicago Economic Perspectives, (1Q) pp. 30-42. Friedman, M. (1968), The Role of Monetary Policy, American Economic Review, 68 (March),pp. 1-17. Lansing, Kevin J. ( 2002) Can the Phillips curve help forecast inflation? FRBSF Economic Letter 02-29 (October 4): 1-4 Mio,H(2001) The Phillips Curve and Underlying Inflation Research Division 1, Institute for Monetary and Economic Studies, Bank of Japan Paul, B.P,(2009), In search of the Phillips curve for India Journal of Asian Economics, Vol. 20 No. 4, pp. 479-488 Ray,L(2011) Estimation of the Phillips curve in the Indian context Department of Economics, School of Management, Pondicherry, University Reserve Bank of India, A handbook on statistics of Indian Economy Singh,K.B (2012), An Assessment of Inflation Modelling in India ICIER Working Paper 259 Stock, J.H. and M.W. Watson (1999), Forecasting Inflation. Journal of Monetary Economics,44(2), 1999, pp 293-335.

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