Conflicts & Trade-Offs Between Objectives & Policies (Edexcel A Level Economics A)

Trade-offs Between Macroeconomic Objectives

• 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

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

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%

Policy Conflicts & Trade-offs

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