Speed of Adjustment and Inflation – Unemployment Tradeoff in Developing Countries – Case of India

This paper estimates the short-run aggregate supply curve for the Indian economy over the period 1950-51 to 2008-09. Methodological improvements in this paper include the technique of estimating adaptive expectations, constrained estimation consistent with long run equilibrium, and introduction of the extended Phillips curve. The study also attempts to investigate the question of speed of recovery and the choice of adjustment paths available to policymakers in face of adverse supply shocks. In order to estimate the inflation-unemployment tradeoff we estimate the regular Phillips curve which lies at the root of the aggregate supply curve. The estimation is based on using adaptive inflationary expectations and supply shocks. We further introduce the extended part of the Phillips curve to analyze the question of speed of recovery and the choice of adjustment path. Contrary to previous studies, the present study finds a regular tradeoff between inflation and output or unemployment with inflationary expectations based on the experience of past three to four years. We also find that the subtle tradeoff between the rate of output recovery and inflation is negative in India thereby implying that a strategy of fast recovery is not likely to result in high inflationary pressures. These findings have important implications for policy choices on growth and strategy for recovery. The current fiscal and monetary policy stance has been strictly anti-inflationary and recognizes that some short-run deceleration in growth is unavoidable for controlling inflation. These policies without any empirical support presuppose the existence of a tradeoff between inflation and output and the choice of strategy for recovery. Our findings show that a strategy of slow recovery and following demand contraction policies to control inflation during the recovery phase could be counterproductive.