Category Archives: Economics

Phillips Curve

An economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. According to the Phillips curve, the lower an economy’s rate of unemployment, the more rapidly wages paid to labour increase in that economy.


Phillips conjectured that the lower the unemployment rate, the tighter the labour market and, therefore, the faster firms must raise wages to attract scarce labour. At higher rates of unemployment, the pressure abated. Phillips’s “curve” represented the average relationship between unemployment and wage behaviour over the business cycle. It showed the rate of wage inflation that would result if a particular level of unemployment persisted for some time.


Phillips found that there was a trade-off between unemployment and inflation, so that any attempt by governments to reduce unemployment was likely to lead to increased inflation. This relationship was seen by Keynesians as a justification of their policies.

Phillip Curve

The curve sloped down from left to right and seemed to offer policymakers a simple choice – you have to accept inflation or unemployment. You can’t lower both.


The movement along the curve, with wages expanding more rapidly than the norm for a given level of employment during periods of economic expansion and slower than the norm during economic slowdowns, led to the idea that government policy could be used to influence employment rates and the rate of inflation. By implementing the right policies, governments hoped to achieve a permanent balance between employment and inflation that would result in long-term prosperity.


In order to achieve and maintain such a scenario, governments stimulate the economy to reduce unemployment. This action leads to higher inflation. When inflation reaches unacceptable levels, the government tightens fiscal policies, which decreases inflation and increases unemployment. Ideally, the perfect policy would result in an optimal balance of low rates of inflation and high rates of employment.



Causes of Unemployment

Unemployment is caused when someone is laid off, fired or quits — and is still looking for a job. This type of natural unemployment always occurs, even in a healthy economy. If someone retires, goes back to school or leaves the work force to take care of children or other family member; that is not unemployment. Also, if someone gives up looking for work, they are also not counted as unemployed by the Federal government. For this reason, some people say the government undercounts the real unemployment rate.

There are many different possible causes of unemployment, and unfortunately for governments, it is never easy to identify which is the most important and what to do about it. The causes of unemployment can be split into two main types:

  1. Demand-side
  2. Supply-side


It is said to occur when there is not enough demand, as a result employers to not need many workers. This leads to demand deficient unemployment.


This is caused when there are too many people looking for a job, and there are not enough jobs in the economy. This can be seen in imperfect labour market. A perfect labour market will always clear and all those looking for work will be working – supply will equal demand.

The other major causes which have been responsible for the wide spread unemployment can be spelt out as under.

1. Population Growth

This is a major problem in developing countries where the population growth is enormous and the economy is not growing at that pace to generate enough jobs. The growth of population directly encouraged the unemployment by making large addition to labour force.

2. Limited Land

Land is a natural resource which is limited in nature, due to its limit the land is not sufficient for the growing population. As a result, there is heavy pressure on the land. In rural areas, most of the people depend directly on land for their livelihood. Land is very limited in comparison to population. It creates the unemployment situation for a large number of persons who depend on agriculture in rural areas.

3. Defective Education System

The education system is still historical and not updated since ages, it is still confined to classrooms and the main aim is to acquire certificates i.e. it is not job oriented. There needs to be a change in the system and it should aim at making students not just look for jobs but should look to create jobs i.e. entrepreneurial.

Types of Unemployment

Unemployment in simple terms is a situation in which an individual in an economy is looking for a job and can’t find one.

Unemployment is often used as a measure of the health of the economy. The most frequently cited measure of unemployment is the unemployment rate. This is the number of unemployed persons divided by the number of people in the labour force.

Economists divide unemployment into a number of different categories, since defining types of unemployment more precisely sheds some light on why unemployment occurs and what can be done about it.

Types of Unemployment

The five major types of unemployment are given below:

Types of Unemployment

1. Structural Unemployment

It refers to unemployment that occurs when workers are not qualified for the jobs that are available. Workers in this case are often out of work for much longer periods of time and often require retraining. Structural unemployment can be a serious problem within an economy, particularly in cases where entire sectors (manufacturing, for instance) become obsolete.

Advances in technology and changes in market conditions often turn many skills obsolete; this typically increases the unemployment rate. For example, laborers who worked on cotton fields found their jobs obsolete with Eli Whitney‘s patenting of the cotton gin. Similarly, with the rise of computers, many jobs in manual book keeping have been replaced by highly efficient software. Workers who find themselves in this situation find that they need to acquire new skills in order to obtain a new job.

2. Cyclical Unemployment

It refers to unemployment that is a product of the business cycle. During recessions, for instance, there is often inadequate demand for labour and wages are typically slow to fall to a point where the demand and supply of labour are back in balance. It is a type that Keynesian economists focus on particularly, as they believe it happens when there is disequilibrium in the economy.

It is also often known as cyclical unemployment because it will vary with the trade cycle. When the economy is booming, there will be lots of demand and so firms will be employing large numbers of workers. Demand-deficient unemployment will at this stage of the cycle be fairly low. If the economy slows down, then demand will begin to fall.

3. Frictional Unemployment

When somebody loses their job (or chooses to leave it), they will have to look for another one. If they are lucky they find one quite quickly, but they may be unlucky and it may take some time. On average it will take everybody a reasonable period of time as they search for the right job. This creates unemployment while they look.

It results from imperfect information and the difficulties in matching qualified workers with jobs. A college graduate who is actively looking for work is one example. Frictional unemployment is almost impossible to avoid, as neither job-seekers nor employers can have perfect information or act instantaneously, and it is generally not seen as problematic to an economy.

4. Seasonal Unemployment

Seasonal unemployment is fairly self-explanatory. Seasonal unemployment is less severe than this, and tends to occur in certain industries. Industries that suffer particularly are:

5. Under-employment or disguised unemployment

This is the type of unemployment which is never practically seen, but only experienced. Suppose a job which can be performed by just 10 worker, has in reality has 20 workers, then the excess 10 workers who are not actually required are said to be under employed or disguised unemployed. In other words, the surplus labor do not make any addition to the output. Technically, their marginal product is zero. Such a situation is called wider-employment or disguised unemployment.

While high unemployment is undesirable, full employment (meaning zero unemployment) is neither practical nor desirable. Generally there is a relationship between inflation and unemployment – the lower the rate of unemployment, the higher the rate of inflation. We will study this in the next topic “Philips Curve


Theory of a Firm

Managerial economics employs economic concepts and principles, which are known as the theory of Firm or ‘Economics of the Firm’. Thus, its scope is narrower than that of pure economic theory

At its simplest level, a business enterprise represents a series of contractual relationships that specify the rights and responsibilities of various parties (see below diagram). People directly involved include customers, stockholders, management, employees, and suppliers.

The economic theory of the firm holds that stockholders should be the prime beneficiaries of an organization’s activities. The theory is associated with top-down leadership and cost cutting through rationalization and downsizing. With immediate stock price dominating management activities, the economic theory of the firm has been criticized as being too short-term, as opposed to the longer-term thinking behind stakeholder theory.

Firms are a useful device for producing and distributing goods and services. They are economic entities and are best analyzed in the context of an economic model.

Theory of Firm

Theory of the firm is related to comprehending how firms come into being, what are their objectives, how they behave and improve their performance and how they establish their credentials and standing in society or an economy and so on. The theory of the firm aims at answering the following questions:

  1. Existence – why do firms emerge and exist, why are not all transactions in the economy mediated over the market?
  2. Which of their transactions are performed internally and which are negotiated in the market?
  3. Organisation – why are firms structured in such a specific way? What is the interplay of formal and informal relationships?
  4. Heterogeneity of firm actions/performances – what drives different actions and performances of firms?

Important concepts in theory of firm are

1. Short run vs. Long run

The behaviour of cost is usually analysed under two set of conditions. Short run is a time period in which the amounts of some input are fixed. Long run is a time period during which there is sufficiently long time to allow full flexibility in all inputs used.

2. Explicit vs. Implicit cost

Explicit cost is a cost that is incurred when an actual cash payment is made for inputs. Explicit costs are those which are clearly stated and recorded such as material costs (prices paid to suppliers), Labour costs (wage paid), depreciation cost on fixed asset and other expenses such as building rental. Implicit cost is the opportunity cost of inputs used in production for which no actual payment is made.

3. Accounting profit vs. Economic profit

Accounting profit consist sales revenue minus the explicit cost of the business. Economic profits consist of sales revenue minus total opportunity cost that is both explicit cost and implicit cost.


Efficient Market Hypothesis

The concept of market efficiency was first developed in the finance literature and its full form was first explained by Engene Fama.  But now-a-days this concept is being used in other areas also.  Efficient market is defined as one where prices fully reflect all the available information.  By definition then there should not exist any unexplained opportunities for profit.

It states that it is impossible to beat the market because prices already incorporate and reflect all relevant information. This is also a highly controversial and often disputed theory.

The definition of efficient market is a little vague and its vagueness it seems, is intentional.  It can be shown that, under certain circumstances, it is not required all market operators to share exactly identical views on the future price.  Some investors may be better informed than others.

The implication of the concept of market efficiency in forex market is interesting.  Let us assume that both spot and forward markets of a currency are characterized by the following condition: (a) There are a large number of investors with ample funds available for arbitrage operations, and (b) There are not exchange controls and also no transaction costs.

In this situation suppose an American investors thinks that spot price of deutsche mark (DM) in terms of the dollar is going to be 15 per cent higher in twelve months than it is to day.  The investor may be able to profit by buying DM forward, and then selling DM spot at the end of 12 months.  If his judgment proves right, his profit will be 15 per cent less the premium paid for forward DM (transaction cost is nil as assumed).  As the market information is perfect, other investors will follow suit, and the forward DM will be bid up until the premium is high enough to prevent any further speculation.

One interesting question is: how long will the speculation continue in the market to have a share of the profit. This is not indefinite, as at some point investors will realize that, although the potential of profit from speculation is not zero, the probable reward is not great enough to compensate for the risk of being wrong.  Thus equilibrium will be reached and speculation will spot at the point where the gap between the forward rate and the expectation of the market of the future spot rate is just equal to the required risk premium charged, or in equation it becomes

Ft (t+1) = Et(St+1) + rt

Where LHS is the logarithm of forward price of DM at time t for delivery at period (t+1) and rt is the risk premium.  In the above equation the forward rate reflects both the publicly available information congealed in the rational expectation Et(St+1) and the attitude of the market towards risk revealed in the risk premium.  Thus the equation shows the equilibrium in the efficient market.  The interpretation of efficiency explained here corresponds to what E.  Fama called semi-strong form of efficiency (FAMA, 1970).  Strong form of efficiency applies when the market price reflects all information, whether publicly available or not.

It is quite possible to imagine a situation where the market price reflects only the restricted information set which can be used in the formation of weakly rational expectations.  Here the expected value in the equation would be conditioned on the past value of the time series, and not on the universe of publicly available information.  This helps in defining a weakly efficient market.


A weakly efficient market is one where the market price reflects the market information in its own past history.  It implies that there no longer exists any opportunity to profit by making use of past time series of prices alone.

One interesting aspect of weakly efficient market is that there will normally remain opportunities to make a profit by the exploitation of information additional to the past time series of prices.  Another implication of market efficiency is the unbiasedness of the market.

A forex market is said to be unbiased when the forward market is efficient and investors are risk neutral, so that the forward rate is equal to the mathematical expectation of the spot rate at the time of the maturation of the contract.

Efficient of inefficient players in the forex market are big and they are equipped with very powerful computers with dedicated software.  In spite of the fact that they have access to massive data set and powerful software, calculations go wrong and survey data repeatedly point out irrational movement of expectations.  May be this is another mystery of the market forces.



Reference: Fama E F, Efficient Capital Markets: A Review of Theory and Empirical Evidence, Journal of Finance, 25, 1970, 383-417

The Invisible Hand

Economy is a tricky thing to control and governments are always trying to figure out how to do it. Back in 1776 economists Adam Smith shocked everyone by saying government should back out and leave people alone to buy and sell amongst themselves. He suggested that if they just leave self-interested traders to compete with one an another markets are guided by positive outcome as if by an invisible hand. If someone charges less than you customers will buy from him instead, you will have to lower the price or offer him something better. Whenever, enough people demand something there will be supply in the market like spoilt children, only in this case everyone is happy

Adam Smith, the father of modern economics believed that there existed an “invisible hand” which ruled over the economic system. According to him the economic system, left to it, is self-regulating. The basic driving force in such a system is trying to enhance its own economic well-being. But the actions of each unit, acting according to its own self-interest, are also in the interests of the economy as a whole.

Producers are led by the profit motive to produce those goods and services which the consumers want. They try to do this at the minimum possible cost in order to maximize their profits. Moreover, if there is competition among a number of producers, they will each try to keep the price of their product low in order to attract the consumers. The goods produced are made available in the market by traders. They also act in their own self-interest. However, in a self-regulating economy, there is rarely any shortage of goods and services.

Decisions to save and invest are also taken by the individual economic units. For example, households save some of their income and deposit part of it in the banks, or invest it in shares and debentures and so on. The producers borrow from the banking system and also issue shares and debentures to finance their investments. In turn, they reinvest a part of their profits.

All the economic functions have been carried out by individuals acting in isolation. There is no government or centralized authority to determine who should produce what and in what quantity, and where it should be made available. Yet in a self-regulating economy there is seldom a shortage of goods and services. Practically everything you want to buy is available in the market. Thus according to Adam Smith, the economic system is guided by the “invisible hand”. In a more technical way we can say that the basic economic problems in a society are solved by the operation of market forces.

Economic Way of Thinking

Economic way of thinking is defined as a way of looking at, and analysing, the way the world works by comparing the costs of an action with the benefits generated

Let us look at how an economist thinks and goes about seeking answers to his questions. There are six key ideas that define the economic way of thinking, given below:

Economic Way of Thinking

1. Trade Off

In today’s world the major problem is scarcity of resources, because of this scarcity there will never be enough of everything to satisfy everyone completely, a choice is a trade-off.

Whenever you choose one thing over another, you are making a tradeoff. You are giving up one thing to get another that you want even more. We have to choose the best alternative amongst the available alternatives. For example, you have INR 25; you have to decide what you will buy with that a snack for a cold drink. Whatever choice you make, you get one and loose one.

Trade-Off is an exchange i.e. letting of one thing for another.

2. Rational Choices

Any choice you make will be a rational choice; a rational choice is a choice which compares cost and benefit. In our earlier example if you are hungry you will choose snacks over cold drink as it will give you more satisfaction than a cold drink.

This point gives rise to a question of what goods and services should be produced and in what quantity. The answer to this question is those goods which people will rationally chose to buy. Example, why are people now purchasing more Samsung phones then Nokia? Answer is more benefit and cost.

3. Benefits

Benefit is measured by economist as ‘the most that a person is willing to give up to get something.” For example, how much are you willing to pay for a pizza by Dominos? Each one of us has in reserve somewhere or the other in our mind a sense of what thing sare really worth. Their maximum value or benefit, and the maximum price we are willing to pay for it.

Benefit is something that is gained or any pleasure derived by an individual; it is determined by the likes and preferences of an individual. For example, an individual might get a kick listening to Heavy Metal, it brings him more satisfaction then a Hip-Hop.

Below grid gives a lighter view on cost and benefits of sleeping an hour late.


4. Opportunity Cost

Opportunity cost is the foregone value associated with the current rather than next-best use of an asset. In other words, cost is determined by the highest-valued opportunity that must be foregone to allow current use.

In our first example of INR 25; cold drink was the opportunity cost of snacks i.e. with rupees 25 you could either buy cold drink or snacks.

5. Margin

Let’s understand this with an example; you have to allocate your next two hours between studying and helping your brother in his project, the choice if not all or nothing. To make this decision you will compare the benefits and allocate the time accordingly. You decide how much time will you allocate to study and how much to help your brother on his project based on margin.

We all know what marginal utility, on similar lines marginal benefit is the additional benefit which a person derives from an increase in activity. For example, you have completed preparing for your exams a day in advance, however the marginal benefit will be derived by you if you revise a night before exams. The marginal benefit here would be better grades.

6. Incentives

Self-interest is what is pursued by every individual on this planet, be it you me or any doctor, politician, civil servant, etc… Incentives are the key forces which drive self-interest amongst every individual. Self-interest does not means selfishness, it is to decide how will you use your resources so that they bring the maximum benefit not only to others but also you.

The idea in economics is to predict self-interested choices people make by looking at the incentive. People take those activities which provide them marginal benefits.


The Stages of Inflation

Inflation passes through three stages. In the first stage the rise in price is slow and gradual. In this stage it is easier to check the inflationary rise in the price of goods and services. But if inflation is not effectively checked in the first stage then it enters the second stage. In second stage inflation becomes a serious headache for the government. The prices of goods and services start rising much more rapidly then before. It not possible to eliminate inflation completely but if the government takes effective steps, it may be possible to prevent a further rise in price level. In the third stage, prices of goods and services now start rising almost every minute and it becomes impossible for the government to check them.

These can be illustrated by an example , in first stage price rise in a proportion is less than the supply of money. If the supply of money increases by 10%, the price rise by 5% or even less than that . In the second stage, the prices rise exactly in the same proportion in which the supply of money increases. In other words, if the supply of money is increased by 10% the price rise also goes by 10%. In the third stage, the price rise in a much greater proportion than the increase in the supply of money. In other words, if the supply of money is 10% price level may rise by 15% or even more.

The three stages of inflation are described below:

1. Pre-full Employment Stage

The rise in price level in the first stage is less than proportionate to the increase in the supply of money. Let us suppose the supply of money increases by 10%. As, a result, there will be immediate rise in the price level. Consequently, the production of goods and services receive stimulus. As a result of increase in output of goods and services, the price level will come down. But if the supply of money is again increased by 10%, the price level will rise up, giving encouragement to the production of goods and services in the economy. In this way if there is continuous increase in the supply of money, a stage will come when the output of goods and services may not increase in the same proportion in which the supply of money increases. The reason being that with the expansion of production, the supply of the factors of production goes on declining.

2. Full Employment Stage

If the supply of money continues to increase without any interruption, then after some time production will cease to increase, or in other words, production will become stagnant. The reason being that all productive resources are already fully employed.  Extra resources are not available for a further expansion of production. Hence, the further expansion of production comes to an end. Since production becomes constant, the price level now starts increasing in the same proportion in which the supply of money increases.

3. Post-full Employment Stage

If the supply of money continues to increase even after the time of full employment, then for some time the price level will increase in the same proportion in which supply of money increases. But after that the supply of money increases so much that the public loses confidence in it and the increase in the price level is much more than the increase in supply of money. For example, if the supply of money is 10%, then the price level increases by 20%, 30% or even 40%. In such a situation, it becomes difficult, to check the rise in the price level. This is the final stage of inflation. In this stage, the prices rise so high that money exchange comes to be replaced by commodity exchange in due course of time



The word stagflation is the combination of two words Stag from stagnation and flation from inflation. In stagflation both the higher level of employment and inflation are attached. It is therefore, also called “Inflationary recession.” According to Keynesian it occurs due to rise in cost of production or fall of supply.  If the supply goes downward it will certainly affect the price level which will go higher, it will also reduce the employment. This may result the stagflation.

Possible causes of stagflation include short supplies of essential commodities (such as oil) and too fast a rise in money supply (which in turn usually reflects government policy). Stagflation occurred in the 70s and 80s. Economic theory prior to that time regarded the combination as unlikely, if not impossible.

Causes of Stagflation

  • Supply Shock
  • Government regulations

Supply shock is a classic example, let us look at it. A supply shock is an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good. This sudden change affects the equilibrium price. As we know supply has inverse relationship with price, so when supply goes down price goes up, causing inflation.

Measures to Control Inflation

As we know Inflation is caused by increase in the number of currency without increasing the amount of stuff. In simple terms, Inflation is MORE money chasing the SAME amount of stuff.

So how do we control inflation? Stop creating money? Reduce the government spending? Stop new money from entering the system? Sell bonds in the market to remove all extra money? Raise Interest Rates?

Let us try and understand this.

The different methods used to control inflation are known as anti-inflationary measures. These measures attempt mainly at reducing aggregate demand for goods and services on the basic assumption that inflationary rise in prices is due to an excess of demand over a given supply of goods and services.

We know that inflation is caused by the failure of aggregate supply to equal the increase in aggregate demand. Inflation can, therefore, be controlled by increasing the supplies and reducing money incomes in order to control aggregate demand.

The various methods to control inflation are given below however the most common ones are Monetary and Fiscal Policies:

1. Monetary Policy

With growth of 3.8%, demand in the economy could be growing faster than capacity can grow to meet it. This leads to inflationary pressures. We can term this demand pull inflation. Therefore, reducing the growth of Aggregate demand, should reduce inflationary pressures.

Monetary policy is the policy of the central bank of the country, which is the supreme monetary and banking authority in a country. The central bank may use such methods as the bank rate, open market operations, the reserve ratio and selective controls in order to control the credit creation operation of commercial banks and thus restrict the amounts of bank deposits in the country. This is known as tight money policy. Monetary policy to control inflation is based on the assumption that a rise in prices is due to a larger demand for goods and services, which is the direct result of expansion of bank credit. To the extent this is true, the central bank’s policy will be successful.

Monetary policy may not be effective in controlling inflation, if inflation is due to cost-push factors. Monetary policy can only be helpful in controlling inflation due to demand-pull factors.

The most extreme monetary measure is the issue of new currency in place of the old currency. Under this system, one new note is exchanged for a number of notes of the old currency. The value of bank deposits is also fixed accordingly. Such a measure is adopted when there is an excessive issue of notes and there is hyperinflation in the country. It is very effective measure. But is in-equitable for its hurts the small depositors the most.

Let us see how increasing the rate can help control inflation

A higher interest rate should also lead to higher exchange rate, which helps to reduce inflationary pressure by

  • Making imports cheaper.
  • Reducing demand for exports and
  • Increasing incentive for exporters to cut costs.

2. Fiscal Policy

It is the policy of a government with regard to taxation, expenditure and public borrowing. It has a very important influence on business and economic activity. Taxes determine the size or the volume of disposable income in the hands of the public. The proper tax policy to control inflation will avoid tax cuts, introduce new taxes and raise the rates of existing taxes. The purpose being to reduce the volume of purchasing power in the hands of the public and thus reduces their demand. A precisely similar effect will be achieved if voluntary or compulsory savings are increased. Savings will reduce current demand for goods and thus reduce the inflationary rise in prices.

As an anti-inflationary measure, government expenditure should be reduced. This indicates that demand for goods and services will be further reduced. This policy of increasing public revenue through taxation and decreasing public expenditure is known as surplus budgeting. However, there is one important difficulty is this policy. It may be easy to increase revenue in times of inflation when people have more money income, but difficult to reduce public expenditure.

During war times as well as during a period of development, it is absolutely impossible to reduce the planned expenditure. If the government has already taken up a scheme or a group of schemes, it is ruinous to give them up in the middle. Therefore, public expenditure cannot be used as an anti-inflationary measure. Lastly, public debt, i.e., the debt of the government may be managed in such a way that the supply of money in the country may be controlled.

The government should avoid paying back any of its previous loans during inflation so as to prevent an increase in the circulation of money. Moreover, if the government manages to get a surplus budget, it should be used to cancel public debt held by the central bank. The result will be anti-inflationary since money taken from the public and commercial banks is being cancelled out and is removed from circulation. But the problem is how to get a budget surplus, which is extremely difficult.

3. Price Control and Rationing

This is the most important and effective method available during war and other critical times particularly because both monetary and fiscal policies are more or less useless during this period. Price control implies the establishment to legal upper limits beyond which prices of particular goods should not rise. The purpose of rationing, on the other hand, is to distribute the goods in short supply in an equitable manner among all people, irrespective of their wealth and social status. Price control and rationing generally go together. The chief objection behind use of this method to fight inflation is that they restrict the freedom of the consumers and thus limit their welfare. Besides, its success depends on administrative efficiency, which in many underdeveloped countries is very low.

4. Other Methods

Another important anti-inflationary device is to increase the supply of goods through either increased production or imports. Production may be increased by shifting factors of production from the production of less inflation sensitive goods, which are in comparative abundance to the production of those goods which are in short supply and which are inflation-sensitive. Moreover, shortage of goods internally may be relieved through imports of inflation sensitive goods, either on credit or in exchange for export of luxury goods and other non-essentials.

A word may be added about the measures to control cost-push inflation. It is suggested that wages, salaries and profit margins should be controlled and fixed through a system of income freeze. Business units may particularly welcome wage freeze. However, wage freeze is not so easy or just, unless trade unions agree to the proposal and there is also freezing of prices. At the same time, the Government should not raise the rates of commodity taxes. Thus, it is difficult to control cost push inflation through controlling wages and other incomes. The best method is to bring a rapid increase in production, which will automatically check prices and wages also.