2.6.4 Conflicts & Trade-offs Between Objectives & Policies

• Policy decisions by governments often create a trade-off 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
Economic Growth & 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%
Economic Growth & 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 & 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
Economic Growth & Balanced Budget	Economic growth driven by expansionary fiscal policy often requires a budget deficit
Economic Growth & Balancing the Current Account	Economic growth usually leads to higher incomes which leads to an increase in imports by households thereby worsening the current account balance
Low Unemployment & 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 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

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 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 & 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 (Y_FE-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%

• Similarly to the trade-offs that exist in achieving the different macroeconomic objectives, there are trade-offs & conflicts that occur with the use of demand-side & supply-side policies

Example 1

• Raising interest rates (contractionary monetary policy), eases demand-side inflationary pressure but raises the cost of borrowing for firms and slows down supply-side investment
  • Tackling short term inflation, delays long term supply-side growth

Example 2

• An increase in government spending (expansionary fiscal policy) can bring about improvements on the supply-side of the economy in the long-run (LRAS)
  • Conversely, it may cause a shortage in short-run aggregate supply (SRAS) as government spending causes excess demand in the economy, leading to inflation

Example 3

• Increased environmental policies may lead to a fall in economic growth and lower LRAS
  • Fossil fuel industries have traditionally enabled increases in LRAS