Conflicts Between the Macroeconomic Objectives (AQA A Level Economics)

• Understanding the relationship between output gaps, unemployment, and inflation is crucial for policymakers
• Reducing a negative output gap by stimulating demand may lead to lower unemployment but could also contribute to inflation
• Conversely, efforts to cool down an overheating economy with a positive output gap might reduce inflation but could result in higher unemployment
  
  

Relationship Between Output gaps & Unemployment / Inflationary Pressures

Macroeconomic Goal	Positive Output Gap	Negative Output Gap
Low unemployment	A positive output gap is associated with higher levels of GDP in the economy, firms operate near or at full capacity The demand for labour is high, leading to lower unemployment rates	A negative output gap is associated with low levels of economic growth There is excess capacity and unused resources in the economy.  Firms may not be operating at full capacity, leading to layoffs and a higher unemployment rate
Low and stable inflation	In a positive output gap scenario, there is upward pressure on prices and wages With firms operating at or near full capacity, they may struggle to meet increasing demand, leading to higher production costs As a result, firms may raise prices, contributing to inflationary pressures Additionally, low unemployment can empower workers to demand higher wages, further fueling inflation	In a negative output gap scenario, there is downward pressure on prices and wages.  High unemployment reduces workers bargaining power, making it difficult for them to negotiate higher wages As a result, firms may not face significant cost pressures, and there is a risk of deflation or very low inflation

• The Short-run Phillips Curve (SRPC) observes that there may be a trade-off between unemployment and inflation
• Rising inflation is often accompanied by falling unemployment
• Rising unemployment is often accompanied by falling inflation
• This trade-off makes it difficult for the government to achieve both low unemployment and low inflation

Diagram: The Short-run Phillips Curve

The relationship between changes to aggregate demand (AD), inflation and unemployment

Diagram analysis

• The economy is initially in equilibrium at AP₁Y_FE
• At this point, unemployment is at 4% and inflation is at 3% and this is considered to be full employment (Y_FE)
  • 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 (Y_FE - Y₂)
  • With an increase in output the demand for labour rises and unemployment falls from 4% → 3%
  • The remaining labour in the market is scarcer and 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 (Y_FE - Y₃)
  • With a decrease in output, the demand for labour falls and unemployment rises from 4% → 5%
  • Labour is more abundant, and 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%

• 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

Diagram: SRPC Self Correction to LRPC

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
    
• 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

The implications for short-run policy decisions

• Governments have to accept  trade-offs in the macroeconomic objectives
• Achieving one objective may come at the cost of worsening progress in another objective
  • Increasing economic growth causes the economy to move closer to full employment
  • However, prices for remaining resources are bid up leading to inflation which may outpace the target inflation rate of 2%
    
    

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

The implications for long-run policy decisions

• LRPC suggests that there is no permanent trade-off between inflation and unemployment over an extended period
• In the long run, the economy tends to return to its natural or potential level of output
  • Policymakers should not use demand side policies (monetary/fiscal) to permanently reduce unemployment below its natural rate.
    • Attempts to do so may lead to higher inflation without sustaining lower unemployment
  • Instead, policymakers should consider supply-side policies, such as education and training programs, labour market reforms, and measures that enhance productivity and efficiency