UNIT 3.2

GOVERNMENT AND THE ECONOMY

3.2.1   • Fiscal Budget

3.2.2   • Unemployment;

3.2.3   • Inflation;

3.2.4   • Growth, price stability and employment;

3.2.5   • Recession

 

Unemployment And Inflation

 

WHAT IS UNEMPLOYMENT

When people who are willing and able to work do not find work they are called unemployed. Unemployment has its social, economic and political implications.

 

CONSEQUENCES OF UNEMPLOYMENT

 

Unemployment has following consequence.

 

(a)        loss of output

 if labour is unemployed, the economy is not producing as much output as it could. Thus, total national income is less than it could be,

 

(b)        loss of 'human capita/'

 if there is unemployment, the unemployed labour 'will gradually lose its skills, because skills can only be maintained by working;

 

(c) increasing inequalities in the distribution of income:

unemployed people earn less  than employed people, and so when unemployment is increasing, the poor get poorer

 

(d) social costs:

unemployment brings social problems of personal suffering and distress, and possibly also increases in crime such as theft and vandalism.

 

TYPES OF UNEMPLOYMENT

 Unemployment may be classified into categories/types.

 

(a) Frictional unemployment.

Unemployment due to friction in the labour market  is called frictional unemployment. Labour force who can find a job but are in search of better job are also part of frictional unemployment. It is caused perhaps by a lack of knowledge about job opportunities. Frictional unemployment is temporary, lasting for the period of transition from one job to the next.

 

(b) Seasonal unemployment.

Unemployment due to seasonal fluctuations  in business activities is called seasonal unemployment. This occurs in certain industries, for example sugar and rice husking industries, where the demand for labour fluctuates in seasonal patterns throughout the year.

 

(c) Structural unemployment

Unemployment due to structural backwardness or transformation of economy is called structural unemployment.  It occurs where long-term changes in the conditions of an industry occur. For example an industry may decline leaving many workers redundant and reluctant to move to a new industry.

 

(d) Technological unemployment.

Unemployment due to technological changes in economy is called technological unemployment. This is also a form of structural unemployment, which occurs when new technologies are introduced. With new technology:

(i)    old skills are no longer required.

(ii)   there is likely to be a labour saving aspect, with machines doing the job that people used to do. 

 

(e) Cyclical or 'demand-deficient' unemployment.

 

Unemployment due to business cycle or recession in an economy is called cyclical unemployment.  During decline and recession years, the demand for output and jobs falls, and unemployment rises to a high level.

 

Cyclical unemployment can be long-term, and a government might try to reduce it by doing what it can to minimize a recession or to encourage faster economic growth.

Seasonal employment and frictional unemployment will be short-term. Structural unemployment, technological unemployment, and cyclical unemployment are all longer term, and more serious.

 

Inflation

MEANING:

            The term inflation refers to increase in general price level over time. Inflation can be defined as “A persistent increase in general price level is called inflation”   The most common definition of inflation is “A situation in which too much money chasses too few goods”

 

WHY IS INFLATION A PROBLEM OR EFFECTS OF INFLATION?

Before considering the benefits of a stable price level, with little or no inflation, it is useful to draw a distinction between inflation which can be perfectly anticipated by everyone and inflation which is unexpected. If inflation is perfectly predicted in advance by everyone, it need not in theory have any significant effects. All transactions would effectively be 'indexed' by the perfectly known rate of inflation and nothing 'real' need be affected. However, perfect knowledge is not in practice available, and inflation has a number of undesirable consequences, as identified below.

 

(1)        Redistribution of income and wealth.

Inflation leads to a redistribution of income and wealth in ways which may be undesirable. Redistribution of wealth might take place from creditors to debtors. This is because debts lose 'real'' value with inflation. For example, if you owed Rs. 1,000, and prices then doubled, you would still owe Rs.1,000, but the real value of your debt would have been halved.

In general, in times of inflation those with economic power tend to gain at the expense of the weak, particularly those on fixed incomes.

 

(2)        Balance of payments effects.

If a country has a higher rate of inflation than its major trading partners, its exports will become relatively expensive and imports relatively cheap. As a result, the balance of trade will suffer, affecting employment in exporting industries and in industries producing import-substitutes.

 

(3)        Uncertainty of the value of money and prices.

If the rate of inflation is imperfectly anticipated, no one has certain knowledge of the true rate of inflation. As a result, no one has certain knowledge of the value of money or of the real meaning of prices. If the rate of inflation becomes excessive, and there is 'hyperinflation', this problem becomes so exaggerated that money becomes worthless, so that people are unwilling to use it and are forced to resort to barter. In less extreme circumstances, the results are less dramatic, but the same problem exists. As prices convey less information, the process of resource allocation is less efficient and rational decision-making is almost impossible.

 

(4)        Resource costs of changing prices.

A fourth reason to aim for stable prices is the resource cost of frequently changing prices. In times of high inflation substantial labour time is spent on planning and implementing price changes. Customers may also have to spend more time making price comparisons if they seek to buy from the lowest cost source.

 

(5)        Economic growth and investment

It is sometimes claimed that inflation is harmful to a country's economic growth and level of investment. Although the adverse influence of inflation on economic growth and investment appears small, some causal effect would appear to exist, which could affect a country's standard of living fairly significantly over the long term.

 

CAUSES OF INFLATION

 

There are number of causes of inflation in a country. Some of the important causes are

 

(1)        Demand pull Factors Or Demand Pull inflation

When aggregate demand exceeds aggregate supply at full employment level, the result is inflation. This type of inflation is usually experienced during the periods of prosperity.

 

(2)        Cost push factors or Cost push inflation

When cost of production increases due to any reason, the prices of output also increase causing inflation in the economy. Such inflation is known as cost push inflation. Increased prices of energy resources, new taxes and increase in wage rate are some reasons for  cost push inflation.

 

(3)        Imported inflation

When there is inflation in a country from where most of the imports come, then increased prices of these imported items cause inflation in the economy. This is known as imported inflation.

 

(4)        Devaluation

Devaluation refers to official decrease in the value of local currency in terms of other countries. Devaluation causes the prices of imported items to rise. This increase in prices is due to devaluation therefore is called imported inflation

 

(5)        Increase in the supply of money

When supply of money increases in an economy it causes the value of money to decrease and general price level to rise.

 

(6)        Mixed Inflation

Sometime cost of production is increasing along with increasing aggregate demand. As a result of these two reasons prices are increasing in economy. Such an inflation which is due to demand pull and cost push reasons it is known as mixed inflation.

 

(7)        Increase in Population

Increase in population is a source of inflation. Rapid increase in population creates excess demand in economy and when population of a country increases but the out put of the country does not increase to meet the increased demand, it results in inflation.

 

MEASURES TO CONTROL INFLATION

Following Measures may help to control inflation in a country.

(1)               Fiscal Measures

(2)        Monetary Measures

(3)        Administrative Measures

(4)        Population Control

(5)        Self sufficiency

(6)        Structural reforms

(7)        Income Policy

(8)        Price policy

 

 

PHILLIPS CURVE

Phillips curve shows relationship between inflation and unemployment. A W Phillips (1958) found a statistical relationship between unemployment and the rate of money wage inflation which implied that, in general, the rate of inflation fell as unemployment rose and vice versa. A curve, known as a Phillips curve, can be drawn linking inflation and unemployment.

 

Two points should be noticed about the Phillips curve.

 

(a) The curve crosses the horizontal axis at a positive value for the unemployment rate. This means that zero inflation will be associated with some unemployment; it is not possible to achieve zero inflation and zero unemployment at the same time.

 

(b) The shape of the curve (concave) means that the lower the level of unemployment, the higher the rate of increase in inflation and vice versa.

The existence of a relationship between inflation and unemployment of the type

indicated by the Phillips curve suggests that the government should be able to choose , some point on the curve, according to its preference, and use demand management policies to take the economy to that point, 'striking a balance' between acceptable levels of inflation and unemployment.

It is felt by economists that in order to achieve full employment, some inflation is unavoidable. If achieving full employment is an economic policy objective, a government must therefore be prepared to accept a certain level of inflation as a necessary 'evil'.

 

Long Run Phillips Curve

Economists discovered that in long run there is no trade off between inflation and unemployment. Some natural rate of unemployment may exist with rising inflation rate. This is explained by using the following diagram.

In this diagram the short run Phillips curve is SRPC. Initially, say, there is an unemployment rate of Un and zero price and wage inflation.

Suppose now that the government' expands aggregate demand so as to reduce unemployment to, say U1 of the labour force. There is a movement along the Phillips curve, and the new unemployment level turns out to be associated with P0 inflation.

Now if government tries to maintain this U1 level of unemployment, the inflation rate tends to increase and if effort is made to restrict the price level at P0 the unemployment tends to increase and it reaches again to Un.

This gives a vertical Phillips curve showing higher inflation and same natural rate of unemployment.

Now the only way to reduce the rate of inflation is to get inflationary expectations out of the system, In doing so, excessive demands for wage rises should be resisted by employers.

 

A strict approach to reducing the rate of inflation could mean having to accept high levels of unemployment for a while.

Attempts to get the unemployment level below its natural rate will only result in the long run in higher inflation. The choice for government is therefore not between inflation or unemployment; instead, a balance or choice must be made between the level of unemployment and the rate of inflation.

 

BUSINESS CYCLES OR TRADE CYCLES

 

Business cycle may be defined as ups and downs in economic activities in an economy.

Or it is the continual sequence of rapid growth in national income, followed by a slow-down in growth and then a fall in national income. After the recession comes growth again, and when this has reached a peak, the cycle turns into recession once more.

Following are the four main phases of the business cycle

(a) Depression      

It is characterized as Heavy unemployment - Low consumer demand, Over-capacity (unused capacity) in production, falling prices, low business profits confidence in the future  is also low

 

(b) Recovery        

Usually recovery is distinguished as, Investment picks up, Employment rises, Consumer spending rises Profits rise, Business confidence grows, Prices stable, or slowly rising.

 

(c) Boom           

Consumer spending rising fast, Output capacity reached, labour shortages occur,

Output can only be increased by new labour-saving, investment, Increases in demand now stimulate price rises Business profits high.

 

(d) Recession        

Consumption falls off, investments suddenly become unprofitable and new investment falls, Production falls, Employment falls and Profits fall. Some businesses fail, Recession can turn into severe depression

Recession tends to occur quickly, while recovery is typically a slower process.

 

A business cycle can be explained with the help of following figure.

In figure the highest point of national income is prosperity and after prosperity the phase of recession starts in. In the recession phase, consumer demand falls and many investment projects already undertaken begin to look unprofitable. Orders will be cut, stock levels will be reduced and business failures will occur as firms find themselves unable to sell their goods.

 

Production and employment will fall. This will lead to a fall in income and expenditure and, as the aggregate level of demand falls, an increasing number of firms will face financial difficulties. The general price level will begin to fall. Business and consumer confidence are diminished and investment remains low, while the economic outlook appears to be poor. Eventually, in the absence of any stimulus to aggregate demand, a period of full depression sets in.

 

   Recession can begin relatively quickly because of the speed with which the effects of declining demand will be felt by businesses suffering a loss in sales revenue. The 'knock-on' effects of destocking and cutting back on investment exacerbate the situation and add momentum to the recession. Recovery can be slow to begin because of the effect of recession on levels of confidence. It can take some time for confidence to return, and initial moves towards expansion of activity are likely to be tentative.

After Depression in the economy, there starts  recovery phase of the cycle. Once begun, the phase of recovery is likely to quicken as confidence returns. Output, employment and income will all begin to rise. Rising production, sales and profit levels will lead to optimistic business expectations, and new investment will be more readily undertaken. The rising level of demand can be met through increased production by bringing existing capacity into use and by hiring unemployed labour. The average price level will remain constant or begin to rise slowly.

In the recovery phase, decisions to purchase new materials and machinery may lead to benefits in efficiency from the fact that it will be possible to take advantage of new technology. This can enhance the relative rate of economic growth in the recovery phase once it is under way.   

During the prosperity, capacity and labour will become fully utilized. This may cause bottlenecks in some industries which are unable to meet increases in demand, for example because they have no spare capacity or they lack certain categories of skilled labour, or they face shortages of key material inputs. Further rises in demand will, therefore, tend to be met by increases in prices rather than by increases in production. In general, business will be profitable, with few firms facing losses. Expectations of the future may be very optimistic and the level of investment expenditure high. The intensity of the rise in the level of economic activity may be increased by speculation, or simply by over-optimism. This can lead to inflationary periods.              

 It can be argued that wide fluctuations in levels of economic activity are damaging to the overall economic well-being of society. The inflation and speculation which accompanies prosperity periods may be inequitable in their impact on different sections of the population, while the bottom of the trade cycle may bring high unemployment. Governments generally seek to stabilize the economic system, trying to avoid the distortions of a widely fluctuating trade cycle.