Potential Conflicts Between Macroeconomic Objectives (DP IB Economics)

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

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
     

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%

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  

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

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