Demonetization Anniversary: Fillip the economy with the Phillips Curve

'Once the true relationship between inflation and unemployment is understood, with luck and skill, a free lunch is possible.' - Paul Ormerod

Before we commence let us understand the basics of the Phillips Curve. The Phillips curve shows the inverse trade-off between inflation and unemployment. As one increases, the other must decrease. The theory states that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. While there is a short run trade-off between unemployment and inflation, it has not been observed in the long run.

The Phillips curve remains the primary framework for understanding and forecasting inflation used in central banks. The 'Phillips Curve Relationship in India: Evidence from State-Level Analysis' published by the department of economic policy and research of RBI in July 2017 confirm the presence of a conventional Phillips curve specification, both for core inflation and headline inflation.

In this image, an economy can either experience 3% unemployment at the cost of 6% of inflation, or increase unemployment to 5% to bring down the inflation levels to 2%.

It is exactly a year since demonetisation has taken place. While the immediate impact of demonetisation was seen in the long queues outside ATMs and felt through acute cash shortage, its anniversary is an appropriate vantage point to assess the less visible and generalised effect on the economy. The GDP has been on the decline and was 5.7% for Q1 of 2017-18. It is expected to further decline in the next quarter. If there is slow economic growth, inflation will be low and hence unemployment will rise as per Phillips curve.

Central bank chiefs thus keep a very close eye on inflation and unemployment data of the overall economy to plan monetary policy accordingly. Whenever inflation is too low and unemployment too high, central banks increase the money supply to encourage greater employment. When this causes inflation to shoot up too high, they reduce the money supply, which results in lower inflation but also slightly higher unemployment. They try to maintain the level of unemployment at the non-accelerating inflation rate of unemployment, which is the unemployment rate at which inflation too is just under control.

Just a fortnight ago, the World Bank Group released a report for rankings on the ease of doing business. India jumped up 30 spots to be part of the top 100 nations. But this ranking has not factored in demonetization impact on businesses. This exclusion raises questions on the basis of the 'doing business' rankings, since such an economic exercise had significant impact on the businesses, both big and small which in turn has an impact on GDP.

With 22% of the population below the poverty line, inflation and unemployment are the most important economic criteria that the RBI has to consider while framing the monetary policy. What does such Phillips curve mean for India's monetary policy going forward? You might think that it is an invitation for policymakers to let unemployment fall well below the natural rate, and that doing so would not risk a significant pickup in inflation. This would be very risky.

In a country like India inflation burns the pocket while unemployment creates a hole in the pocket. Hence it is necessary to keep a good balance between these two important economic criteria (inflation and unemployment) for the overall growth of the economy as it will lead to financial inclusion of all sectors of society. The Phillips Curve is instrumental to keep a good balance between inflation and unemployment. If Paul Ormerod's quote as mentioned in the beginning is to be taken literally, then the entire cost of the mid-day meal scheme of the Government of India will indeed be free!!!