6. Economics Notes 28

Elaborate Notes

How to Handle Unemployment

Unemployment is a macroeconomic challenge characterized by a situation where individuals who are able and willing to work at the prevailing wage rate are unable to find employment. Addressing this requires a multi-pronged strategy focusing on both demand and supply sides of the labor market.

• Focus on Labor-Intensive Sectors: The primary strategy involves promoting sectors with a high elasticity of employment, meaning a given amount of investment generates a large number of jobs.

  • Context: In the late 20th and early 21st centuries, China became the “world’s factory” by leveraging its massive labor force for manufacturing. As China’s economy matured and its labor costs rose, it began transitioning towards high-end, capital-intensive manufacturing. This shift created a vacuum in low-cost, labor-intensive manufacturing.
  • Examples: Countries like Bangladesh (in textiles and readymade garments), Vietnam (in electronics assembly and footwear), and Ethiopia (in leather goods and textiles) successfully captured parts of this market. For India, sectors like Tourism, Footwear, Textiles and Apparels, and Gems and Jewellery offer immense potential for job creation.
  • Scholarly View: Economists like Jagdish Bhagwati and Arvind Panagariya have consistently advocated for India to focus on labor-intensive export-oriented manufacturing to leverage its demographic dividend.

• Skill Development: This addresses the supply-side issue of a mismatch between the skills possessed by the workforce and the skills demanded by industries.

  • Vocational Training: This involves providing practical, hands-on training for specific trades (e.g., plumbing, welding, data entry). The National Skill Development Corporation (NSDC) and schemes like Pradhan Mantri Kaushal Vikas Yojana (PMKVY) are government initiatives in this direction.
  • Job-Oriented Training: This is tailored to the immediate needs of specific industries, often involving collaboration between educational institutions and corporations to ensure curriculum relevance and job placement.

• Labor-Intensive Manufacturing Sector (MSMEs): The Micro, Small, and Medium Enterprises (MSME) sector is often termed the “engine of growth” for the Indian economy.

  • Significance: MSMEs are inherently more labor-intensive than large corporations. According to the MSME Ministry’s Annual Report, this sector is the second-largest employer after agriculture and contributes significantly to GDP and exports. Promoting MSMEs through easier credit access (MUDRA scheme), technological upgradation, and market linkages can generate widespread employment.

• Focus on Sunrise Industries: These are new and rapidly growing industries with high potential for future growth and employment.

  • Food Processing Sector: This sector is a prime example. It has strong forward and backward linkages with agriculture and manufacturing. By creating a bridge between farmers and consumers, it can reduce post-harvest losses, add value to agricultural produce, and create jobs in logistics, processing, packaging, and retail. Government initiatives like the PM Formalisation of Micro food processing Enterprises (PMFME) Scheme aim to boost this sector.

Inflation

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money.

• Measurement: It is typically measured using a Price Index, such as the Consumer Price Index (CPI) or Wholesale Price Index (WPI). The index represents the average price of a basket of goods and services. The inflation rate is the percentage change in this index over a specific period, usually compared to a Base Year, which serves as a benchmark.

Types of Inflation

Inflation is categorized based on its rate of increase.

• 1) Creeping Inflation:

  • Definition: This is a mild form of inflation where prices rise at a very slow rate, typically in the low single digits (e.g., 2-3% per annum).
  • Economic Impact: It is generally considered beneficial for an economy. As argued by some Keynesian economists, a mild level of inflation can “grease the wheels” of the economy. It provides producers with reasonable profits, which incentivizes them to invest in new capital and expand production, leading to economic growth and employment. The Reserve Bank of India’s flexible inflation targeting framework (4% +/- 2%) operates on this principle.

• 2) Walking (or Trotting) Inflation:

  • Definition: When prices rise at a moderate rate, typically between 3% and 10% per annum.
  • Economic Impact: This level of inflation is a cause for concern. It can start to distort economic decisions as people may begin to buy more than they need to avoid future higher prices, leading to excess demand. Policymakers view it as a warning signal that inflation could accelerate into a more dangerous form if not controlled.

• 3) Galloping Inflation:

  • Definition: A very high rate of inflation, running into double or even triple digits (e.g., 10% to 50% or higher per annum). It is also known as Running Inflation.
  • Economic Impact: Galloping inflation has serious negative consequences. Money loses value so quickly that people try to avoid holding it. Savings are wiped out, hitting the middle class and the poor the hardest. It creates extreme uncertainty, causing foreign investors to shun the economy, leading to capital flight. Several Latin American countries, such as Argentina and Brazil, experienced periods of galloping inflation in the 1980s.

• 4) Hyperinflation:

  • Definition: An extreme and out-of-control form of inflation, where prices increase at an astronomical rate (often defined as more than 50% per month).
  • Causes: It is almost always caused by a massive and rapid increase in the money supply, typically when a government prints money to finance its spending without any corresponding increase in the output of goods and services.
  • Historical Examples:
    • Weimar Republic (Germany) 1922-23: After World War I, the German government printed vast sums of money to pay war reparations, leading to a catastrophic collapse of the currency where prices doubled every few days.
    • Zimbabwe (2008-09): The government’s policies, including land reforms and excessive money printing to fund deficits, led to an estimated peak monthly inflation rate of 79.6 billion percent in November 2008. The country eventually had to abandon its currency.
    • Venezuela (2019): A combination of economic mismanagement, political instability, and falling oil prices led to hyperinflation, rendering the national currency, the Bolívar, nearly worthless.
    • Iran (2020): Facing severe economic sanctions, Iran experienced high inflation, prompting the government in May 2020 to announce a plan to re-denominate its currency, the rial, by slashing four zeros and renaming it the toman.

Demand-Pull Inflation

This type of inflation occurs when aggregate demand in an economy outpaces aggregate supply. It is often described by the phrase “too much money chasing too few goods.”

• Mechanism: When consumers, businesses, or the government have more money to spend (disposable income), they increase their demand for goods and services. If the economy’s productive capacity (supply) cannot keep up with this increased demand, producers raise their prices to ration the limited supply and maximize profits.

• Keynesian Perspective: This concept is central to John Maynard Keynes’s work, particularly in “The General Theory of Employment, Interest and Money” (1936), where he linked aggregate demand to overall economic activity and price levels.

• Demand-Pull Factors:

  • Expansionary Fiscal Policy: An increase in government expenditure (e.g., on infrastructure or welfare schemes) or a reduction in taxes (fiscal stimulus) increases the overall demand in the economy.
  • Expansionary Monetary Policy: An increase in the money supply or a reduction in interest rates by the central bank makes credit cheaper, encouraging borrowing and spending by both consumers and businesses.
  • Rising Population: A growing population naturally increases the demand for basic goods and services like food, housing, and clothing.
  • Black Money: The circulation of unaccounted money creates artificial demand, particularly in sectors like real estate and luxury goods, driving up prices.
  • Hoarding: When consumers or traders anticipate future price rises, they may hoard essential commodities, creating an artificial scarcity that further pushes up prices.
  • Change in Consumption Patterns: A shift in consumer preferences can increase demand for certain goods. Example: The implementation of MGNREGA increased rural incomes, which reportedly led to higher consumption of protein-rich foods like eggs and poultry, contributing to their price rise.
  • Inflation Expectations: If people expect prices to rise in the future, they will demand higher wages and may increase their current spending, creating a self-fulfilling prophecy.

Cost-Push Inflation

This type of inflation, also known as supply-shock inflation, arises from a decrease in aggregate supply, caused by an increase in the cost of production, independent of the level of aggregate demand.

• Mechanism: When the costs of factors of production (land, labor, capital, raw materials) increase, producers are forced to raise the prices of their final goods and services to maintain their profit margins. This leads to a rise in the general price level.

• Cost-Push Factors:

  • Wage-Price Spiral: This is a classic feedback loop. When workers demand and receive higher wages, firms’ production costs increase, leading them to raise prices. The higher prices then erode the real purchasing power of the new wages, leading workers to demand another wage hike, and the cycle continues.
  • Imported Inflation: An increase in the price of imported goods, especially crucial raw materials like crude oil, raises production costs for domestic industries.
    • Historical Example: The 1973 Oil Shock, when the Organization of the Petroleum Exporting Countries (OPEC) proclaimed an oil embargo, led to a quadrupling of oil prices. This caused a massive surge in inflation and economic stagnation (stagflation) across the globe.
  • Increase in Indirect Taxes: Taxes like Goods and Services Tax (GST) are levied on goods and services. An increase in these tax rates directly adds to the final price paid by the consumer.
  • Increase in Administered Prices: When the government increases prices it controls, such as the Minimum Support Price (MSP) for crops or (historically) the prices of petrol and diesel, it has a cascading effect on the economy, increasing food and transportation costs.
  • Cartelization: When a group of producers collude to restrict output and fix prices at a higher level (forming a cartel), it creates an artificial supply shock. This is sometimes alleged to happen in agricultural mandis among traders.
  • Supply Chain Disruptions: Events like natural disasters, wars, or pandemics can disrupt the production and distribution of goods, leading to shortages and price increases.

Structural Inflation

This concept, primarily developed by structuralist economists in Latin America during the 1950s and 1960s (like Raúl Prebisch), argues that inflation in developing countries can be caused by fundamental rigidities and bottlenecks in the economic structure.

• Mechanism: It is a long-term phenomenon where inflation persists due to structural problems rather than just excess demand or cost shocks. These bottlenecks prevent supply from adapting to changes in demand.
• Examples of Structural Issues:
  • Agricultural Backwardness: Inefficient farming techniques, dependence on monsoon (rainfed agriculture), lack of irrigation, and droughts lead to food shortages and price volatility.
  • Inadequate Infrastructure: Poor storage facilities (leading to post-harvest losses), inefficient distribution networks (fragmented supply chains with many middlemen), and poor transportation increase the final cost of goods.
  • Resource Constraints: Scarcity of essential infrastructure like power and capital can limit industrial expansion.
• Solution: Tackling structural inflation requires long-term structural reforms such as agricultural reforms, investment in infrastructure, and improving the efficiency of markets, rather than just short-term monetary or fiscal policies.

Impact of Inflation

Inflation has varied and significant impacts on different segments of the economy and society.

• On Creditors and Debtors:

  • Creditors (Lenders/Bondholders): They lose during periods of unanticipated inflation. The money they are repaid has less purchasing power than the money they originally lent.
  • Debtors (Borrowers): They benefit from unanticipated inflation because they repay their loans with money that is worth less than when they borrowed it.

• On Income Distribution:

  • Fixed Income Groups: Individuals with fixed incomes, such as wage earners, informal workers (who lack bargaining power), and pensioners, are hit the hardest. Their income does not rise with prices, leading to a decline in their real income and standard of living.
  • The Poor: Inflation acts as a regressive tax, disproportionately affecting the poor as they spend a larger portion of their income on essential commodities (like food and fuel), which often see the sharpest price rises.

• On External Sector:

  • Exports: Inflation increases the cost of production, making domestically produced goods more expensive. This reduces their competitiveness in international markets, leading to a fall in exports.
  • Imports: As domestic goods become costlier, imported goods become relatively cheaper, leading to an increase in imports.
  • Current Account Deficit (CAD): The combination of falling exports and rising imports widens the trade deficit and, consequently, the CAD.
  • Exchange Rate: An increased demand for foreign currency (to pay for more imports) and a reduced supply (from fewer exports) puts downward pressure on the domestic currency, leading to its depreciation.

• On Government Finances:

  • Fiscal Deficit: Inflation increases the cost of government projects and public services. While it can also increase nominal tax revenues (fiscal drag), the pressure on expenditure often leads the government to borrow more, potentially increasing the fiscal deficit. Higher inflation also typically leads to higher interest rates, making government borrowing more expensive.

• On Savings and Investment:

  • Inflation erodes the real value of savings, discouraging people from saving in financial assets. It can also create uncertainty, which can deter long-term investment.

• On Employment (The Phillips Curve):

  • Concept: The Phillips Curve, proposed by economist A. W. Phillips in a 1958 paper, suggests a stable, inverse relationship between the rate of inflation and the rate of unemployment in the short run. The theory is that to reduce unemployment, policymakers might have to accept a higher rate of inflation, and vice versa.
  • Long-Run Critique: Monetarist economists like Milton Friedman and Edmund Phelps (in the late 1960s) argued that this trade-off exists only in the short run. In the long run, they proposed, there is no trade-off, and the Phillips curve becomes vertical at the Natural Rate of Unemployment (or what is now often called the Non-Accelerating Inflation Rate of Unemployment - NAIRU). Any attempt to keep unemployment below this natural rate through demand-side policies will only lead to accelerating inflation.

Measurement of Inflation

• Methods: Point-to-point method (comparing the price index of a month or week with the corresponding period in the previous year) is the most commonly used method for reporting annual inflation.

• Wholesale Price Index (WPI):

  • Definition: WPI measures the average change in the prices of goods sold in the wholesale market. It tracks prices at the producer/factory level.
  • Compiler: It is compiled and published monthly by the Office of the Economic Adviser, Department for Promotion of Industry and Internal Trade (DPIIT), Ministry of Commerce and Industry.
  • Basket & Base Year: The current WPI series has a base year of 2011-12 and includes 697 commodities. A major limitation is that it does not include services.
  • Component Weights (2011-12 series):
    1. Primary Articles: 22.62% (Includes food articles, non-food articles, and minerals)
    2. Fuel and Power: 13.15% (Includes mineral oils, electricity, coal)
    3. Manufactured Products: 64.23% (Largest weightage, includes a wide range of goods)
  • Note on 2011-12 Series: The revision to the 2011-12 base year from 2004-05 saw an increase in the weightage of primary articles and a decrease in the weightage of fuel & power and manufactured products, reflecting structural changes in the economy.

• WPI Food Index:

  • Introduced in 2017 by the DIPP (now DPIIT).
  • It is a separate index that measures the rate of inflation in food items by combining items from the ‘Food Articles’ group under Primary Articles and ‘Food Products’ group under Manufactured Products in the WPI basket. This allows for a more focused monitoring of food inflation at the producer level.

• Base Year and Base Effect:

  • Base Year: A reference year against which price changes in subsequent years are measured. It is chosen to be a normal year, free from major economic shocks, natural calamities, or high price volatility. It should also be a relatively recent year to reflect the current structure of the economy.
  • Base Effect: Refers to the impact of the price level of the previous year (the ‘base’) on the calculation of the current year’s inflation rate. A low base from the previous year can make the current inflation figure appear high, even if the month-on-month price increase is modest. Conversely, a high base can make the current inflation figure appear low.

• Other Price Indices:

  • Producer Price Index (PPI): Measures the average change in selling prices received by domestic producers for their output. It tracks price changes from the perspective of the seller.
  • Consumer Price Index (CPI): Measures the average change in prices paid by consumers for a basket of goods and services. It is a measure of retail inflation.
  • GDP Deflator: Calculated as (Nominal GDP / Real GDP) x 100. It is the most comprehensive measure of inflation as it covers all goods and services produced in the economy. However, it is released with a significant lag and is not used for short-term policy formulation. It also excludes the price of imported goods.

Headline vs. Core Inflation

• Headline Inflation: This is the raw inflation figure reported through the primary price index (like CPI or WPI). It captures the total inflation in an economy and includes price changes for all commodities in the basket, including volatile items like food and fuel.

• Core Inflation: This measure is derived by excluding the volatile components—typically food and energy (fuel & power) prices—from the headline inflation figure.

  • Rationale: Food and fuel prices are often subject to temporary shocks (e.g., bad monsoon, global oil price fluctuations) that may not reflect the underlying inflationary trend. By removing them, policymakers and economists can get a clearer picture of the more persistent, long-term inflation dynamics in the economy, which is more responsive to monetary policy.

Reasons for Increase in WPI in the Recent Past

• Supply Chain Disruptions: The post-COVID-19 economic recovery and global events like the Russia-Ukraine conflict have severely disrupted global supply chains, increasing the cost of raw materials, crude oil, fertilizers, and other essential commodities.
• Adverse Weather Events: Domestically, factors like excessive heatwaves and uneven monsoon rainfall have negatively impacted agricultural output, putting upward pressure on food prices at the producer level.
• Imported Inflation: WPI is particularly sensitive to global commodity prices because items like mineral oils and basic metals have significant weight. The Reserve Bank of India (RBI) has noted that WPI inflation is significantly influenced by global price movements, with one estimate suggesting that for every 1% increase in global prices, WPI inflation can increase by 1.63%.

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Prelims Pointers

• Labor-Intensive Sectors: Tourism, Footwear, Textiles, Gems and Jewellery.
• Sunrise Industry Example: Food Processing Sector.
• Inflation: A sustained rise in the general price level of goods and services.
• Creeping Inflation: Mild inflation, between 2-3%. Considered good for the economy.
• Walking (Trotting) Inflation: Price rise between 3-10%.
• Galloping Inflation: High inflation, from 10% up to 50%. Also called Running Inflation.
• Hyperinflation: Extreme inflation, with price rise of more than 50% per month.
• Hyperinflation Examples: Zimbabwe (2009), Venezuela (2019), Weimar Republic Germany (1923), Iran (2020 currency re-denomination).
• Demand-Pull Inflation: Caused by aggregate demand exceeding aggregate supply (“too much money chasing too few goods”).
• Cost-Push Inflation: Caused by an increase in the cost of factors of production. Also called supply-shock inflation.
• Wage-Price Spiral: A feedback loop where rising wages cause rising prices, which in turn cause demands for higher wages.
• Structural Inflation: Long-term inflation caused by structural bottlenecks in the economy.
• Phillips Curve: Shows an inverse relationship between the rate of inflation and the rate of unemployment in the short run. Proposed by A.W. Phillips (1958).
• Impact of Inflation:
  • Benefits debtors.
  • Harms creditors, lenders, bondholders.
  • Negatively impacts fixed-income groups like pensioners and wage earners.
  • Makes exports non-competitive and increases imports.
  • Can lead to currency depreciation.
• Wholesale Price Index (WPI):
  • Published by: Office of the Economic Adviser, DPIIT, Ministry of Commerce and Industry.
  • Measures wholesale price changes.
  • Base Year: 2011-12.
  • Total Commodities: 697.
  • Does not include services.
  • Major component by weight: Manufactured Products (64.23%).
• WPI Food Index: Started in 2017 by DIPP (now DPIIT) to monitor food inflation at the producer level.
• Base Effect: Impact of the previous year’s price level on the calculation of the current year’s inflation rate.
• GDP Deflator: (Nominal GDP / Real GDP) x 100. It is the most comprehensive inflation measure but is published with a lag.
• Headline Inflation: The total inflation figure for an economy, including all commodities.
• Core Inflation: Headline inflation minus the volatile components like food and fuel prices. Used by policymakers to gauge underlying inflation.
• Imported Inflation: Rise in domestic prices due to an increase in the prices of imported goods.

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Mains Insights

1. Unemployment: The Challenge of Jobless Growth and the Demographic Dividend

• Cause-Effect Relationship: While India has experienced high GDP growth rates in recent decades, this has not translated into commensurate job creation, a phenomenon often termed ‘jobless growth’. The growth has been driven more by capital-intensive and high-skill sectors (like IT and finance) rather than labor-intensive manufacturing.
• Analytical Perspective: This poses a critical challenge to harnessing India’s ‘demographic dividend’. A large young population without adequate employment opportunities can transform the dividend into a ‘demographic disaster,’ leading to social unrest and economic stagnation.
• Policy Implications: A holistic strategy is required. ‘Make in India’ must pivot towards labor-intensive sectors. ‘Skill India’ must be aligned with industry demands to address the skill gap. Simultaneously, promoting MSMEs and sunrise sectors like food processing is crucial for creating jobs at the grassroots level. The debate is not just about creating jobs, but about creating productive, formal-sector jobs with social security.

2. The Inflation Dilemma: Growth vs. Stability

• Historiographical Viewpoint: The debate over the acceptable level of inflation is central to macroeconomic policy. While Keynesian thought suggests a little inflation can stimulate growth (as seen in the Phillips Curve concept), monetarists led by Milton Friedman argue that stable, low inflation is a prerequisite for sustainable long-term growth.
• Indian Context: The RBI’s Flexible Inflation Targeting (FIT) framework, with a target of 4% (+/- 2%) CPI inflation, represents a policy consensus that price stability is the primary objective of monetary policy. However, in a developing economy like India, there is a constant tension between controlling inflation and promoting growth. Tightening monetary policy to curb inflation can stifle investment and slow down economic activity, adversely affecting employment.
• Current Challenge: Today’s global inflation is a complex mix of demand-pull (pent-up demand post-pandemic) and cost-push (supply chain shocks, war). This complicates the policy response. Relying solely on monetary policy (interest rate hikes) to tackle supply-side inflation can be ineffective and may lead to stagflation (high inflation combined with low growth and high unemployment).

3. Structural Bottlenecks and Persistent Food Inflation in India

• Analysis: A significant portion of India’s inflation, especially food inflation, can be classified as ‘structural’. Despite being a major agricultural producer, India frequently witnesses sharp spikes in the prices of essential food items.
• Root Causes:
  1. Supply Chain Inefficiencies: Fragmented value chains with multiple intermediaries, lack of modern logistics, and inadequate cold storage facilities lead to high post-harvest losses (as highlighted by the Ashok Dalwai Committee on Doubling Farmers’ Income).
  2. Market Distortions: The APMC (Agricultural Produce Market Committee) acts in many states have created monopolistic cartels, preventing farmers from getting fair prices and adding to consumer costs.
  3. Agricultural Dependencies: Over-reliance on monsoons and low productivity in certain crops create supply-side vulnerabilities.
• Conclusion: This implies that merely using monetary policy is insufficient. Long-term solutions lie in structural reforms such as amending APMC laws, investing in agri-infrastructure (warehousing, cold chains), and promoting food processing industries to absorb surplus produce.

4. WPI vs. CPI: The Evolution of India’s Monetary Policy Anchor

• Debate: For a long time, WPI was the headline inflation measure in India. However, there has been a definitive shift towards using CPI as the nominal anchor for monetary policy, institutionalized by the adoption of the FIT framework recommended by the Urjit Patel Committee (2014).
• Rationale for the Shift:
  1. Relevance to Consumers: CPI directly measures retail prices and the cost of living for the average consumer, which is the ultimate goal of maintaining price stability. WPI reflects producer prices and does not capture the full impact of inflation on households.
  2. Inclusion of Services: WPI does not include services, which form a significant and growing part of the Indian economy and household consumption baskets. CPI includes services like education, healthcare, and transport.
  3. Global Standard: Most central banks across the world target consumer price inflation for their monetary policy decisions.
• Significance: This shift makes the RBI’s policy more aligned with the welfare of the general public and brings it in line with international best practices. However, WPI remains a crucial indicator for tracking inflation at the producer and wholesale levels. The divergence between WPI and CPI often provides important insights into pricing pressures at different stages of the supply chain.