July 14, 2008
Abstract: An adverse macroeconomic situation (declining industrial production, widening fiscal and current account deficits, high interest rates) can be tackled by appropriate policies. But the duration and intensity of the adjustment depends on certain institutional features or “shock absorbers”. For example, an adverse supply shock (say through higher oil and commodity prices) will result in lower growth and higher inflation. This brings into play two sets of shock absorbers– unemployed workers and producers with excess capacity–who will lower their wage demands and product prices, respectively. This causes inflationary expectations to moderate and leads to an across-the-board lowering of wages and prices, and improves the growth prospects. The duration of recovery will depend upon how easily prices can be lowered and how quickly these lower inflationary expectations. Additionally, two separate shock absorbers are available to deal with external consequences: one, foreign exchange reserves to tide over till recovery starts and, two, adjustments to the exchange rate.
Keywords: adverse macroeconomics; wages; prices; inflationary expectations