Potential Conflicts Between Macroeconomic Objectives (DP IB Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
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
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High economic growth and inflation |
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High economic growth and environmental sustainability |
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Economic growth and inequality |
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Low unemployment and low inflation |
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Examiner Tips and Tricks
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
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
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
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