Potential Conflicts Between Macroeconomic Objectives (HL IB Economics)

Revision Note

Common Conflicts Between the Macroeconomic Objectives

  • Policy decisions by governments often create trade-offs in the macroeconomic objectives

  • Achieving one objective may come at the cost of worsening progress in another objective

An Explanation of the Common Trade-offs that Exist Between the Macroeconomic Objectives


Trade-off


Explanation

High economic growth and inflation

  • Increasing economic growth causes the economy to move closer to full employment

  • Prices for remaining resources are bid up leading to inflation which may outpace the target inflation rate of 2%

High economic growth and environmental sustainability

  • Economic growth often increases pollution, negative externalities and the depletion of non-renewable resources

  • The higher the growth, the faster the depletion

Economic growth and inequality

  • During periods of high economic growth, the profits the owners of the factors of production receive are disproportionate to any increase in workers' wages leading to greater inequality

Low unemployment and low inflation

  • The closer an economy moves to full employment the less workers will be available for hire and wage inflation will help increase overall inflation

Examiner Tip

If you are asked to explain a particular trade off, make sure you explain all of the steps in the process E.g. if economic growth increases too quickly, there is likely to be demand-pull inflation, which raises the cost of living for the citizens, resulting in them feeling poorer, as the purchasing power of their wage has decreased

Inflation & Unemployment Trade-offs: The Short-run Phillips Curve

  • The Short-run Phillips Curve (SRPC) observes that there may be a trade-off between unemployment and inflation

    • Rising inflation is accompanied by falling unemployment

    • Rising unemployment is accompanied by falling inflation

    • This trade-off makes it difficult for the government to achieve both low unemployment and low inflation
       

2-6-4-short-run-phillips-curve-_edexcel-al-economics

The Short-run Phillips Curve illustrates the relationship between changes to aggregate demand (AD), inflation & unemployment
 

Diagram Analysis

  • The economy is initially in equilibrium at AP1YFE

  • At this point, unemployment is at 4% and inflation is at 3% and this is considered to be full employment (YFE)

    • There is always some unemployment due to the frictional and structural unemployment that exists

  • An increase in AD from AD1→AD2 causes a positive output gap (YFE-Y2)

    • With an increase in output the demand for labour rises & unemployment falls from 4%→3%

    • The remaining labour in the market is scarcer & workers are able to negotiate higher wages

      • This causes wage inflation in the economy

    • Wage inflation leads to an increase in inflation from 3%→4%

  • A decrease in AD from AD1→AD3 causes a negative output gap (YFE-Y3)

    • With a decrease in output the demand for labour falls & unemployment rises from 4%→5%

    • Labour is more abundant & to get hired workers have to accept lower wages

      • This causes wage deflation in the economy

    • Wage deflation leads to a decrease in inflation from 3%→2%

Inflation & Unemployment Trade-offs: The Long-run Phillips Curve

  • The long-run Phillips curve (LRPC) suggests there is no trade-off between inflation and unemployment in the long run 

  • The curve is based on the idea of a natural rate of unemployment (NRU)

    • This is the unemployment rate that prevails when the economy is operating at its full potential

    • It represents the level of unemployment consistent with non-accelerating inflation, meaning that further reductions in the unemployment rate cannot be achieved without generating inflationary pressures 

  • The LRPC is vertical at the natural rate of unemployment

    • In the long-run, the short-run Phillips curve moves around the vertical long run curve as the labour market self corrects in the long run

    • In the long-run wages and prices are flexible
       

SRPC Self Correction to LRPC During Inflationary Period  

ibdp-economics---short-run-philips-curve-moving-around-the-long-run-curve

The LRPC for India is evident at the NRU (around 4.5%). In the long-run the SRPC will self correct by moving right to the LRPC  

Diagram Analysis

  • The NRU of 4.5% represents the LRPC

  • in the short-run, AD has increased causing a leftward movement along the SRPC from point A → B (higher inflation and lower unemployment)

  • In the long-run, the economy will move from point B to C as following the increase in AD, workers see their real wages fall and so eventually demand higher wages

    • In response, firms reduce employment and raise prices returning unemployment to its natural rate (NRU), now at a higher inflation rate  

SRPC Self Correction to LRPC During Deflationary Period

ibdp-economics---short-run-phillips-curve-movement-during-deflationary-period

The LRPC for India is evident at the NRU (around 4.5 %). In the long-run the SRPC will self correct by moving left to the LRPC
 

Diagram Analysis

  • The NRU of 4.5 % represents the LRPC

  • in the short-run, AD has decreased causing a rightward movement along the SRPC from point A → B (lower inflation and higher unemployment)

  • In the long-run, the economy will move from point B to C as following the decrease in AD, workers who became unemployed accept lower wages

    • In response, firms increase employment and output returning unemployment to its natural rate (NRU), now at a lower inflation rate 

  • If there has been deflation in the economy, workers will accept lower wages in the long-run and employment and output will return to the full-employment level

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