4.2.3.4 possible conflicts between macroeconomic policy objectives

Question 1

economic growth vs inflation
explain the trade off

Answer 1

• a growing economy is likely to experience inflationary pressures on the average price level
• this is especially true when there’s a positive output gap and aggregate demand is increasing faster than aggregate supply

Question 2

when does a negative output gap occur?
how does it relate to inflation and unemployment?

Answer 2

• when the actual level of output is less than the potential level of output
• puts downward pressure on inflation
• usually means there’s the unemployment of resources in an economy
• so labour and capital aren’t used to their full productive potential
• meaning there’s a lot of spare capacity in the economy

Question 3

when does a positive output gap occur?
how does it relate to inflation and unemployment?

Answer 3

• occurs when the actual level of output is greater then the potential level of output
• could be due to resources being used beyond the normal capacity, such as if labour works overtime
• if productivity is growing, the output gap becomes positive
• puts upward pressure on inflation
• countries like China and India which have high rates of inflation due to fast and high demand
• they’re associated with positive output gaps

Question 4

what is the trade off between economic growth and the current account?

Answer 4

• during periods of economic growth, consumers have high levels of spending
• in the UK, consumers have a high marginal propensity to import
  -> so there’s likely to be more spending on imports
• this leads to a worsening of the current account deficit
  -> however, export-led growth such as that of China and Germany means a country can run a current account surplus and have high levels of economic growth

Question 5

what’s the trade off between economic growth and the government budget deficit?

Answer 5

• reducing a budget deficit requires less expenditure and more tax revenue
  -> this would lead to a decrease in aggregate demand
  -> however, as a result there will be less economic growth

Question 6

what’s the trade off between economic growth and the environment?

Answer 6

• high rates of economic growth are likely to result in high levels of negative externalities
  -> like pollution and usage of non-renewables
• this is due to more manufacturing which is associated with higher levels of carbon dioxide emissions

Question 7

what’s the trade off between unemployment and inflation?

Answer 7

• in the short run, there’s a trade-off between the level of unemployment and the inflation rate
  -> this is illustrated with a Phillips Curve
• as economic growth increases, unemployment decreases due to more jobs being created
  -> but this causes wages to increase, which can lead to more consumer spending and an increase in the average price level

Question 8

what does the Phillips curve look like?

Answer 8

Question 9

how can the extent of the trade off between unemployment and inflation be limited?

Answer 9

by supply-side policies
if they’re used to decrease structural unemployment
-> which will increase average wages

Question 10

what does the short-run Phillips curve represent?
what shape is it?
what does it show?

Answer 10

• trade off between unemployment and inflation
• in the short run, the Phillips curve is roughly L- shaped
  -> which shows how as unemployment increases, inflation decreases

Question 11

what does the long run Phillips curve represent?
what shape is it?

Answer 11

• long run Phillips curve is L-shaped
  -> aka the vertical long-run Phillips curve
• it’s at the natural rate of unemployment
  -> and there’s no trade-off between unemployment and inflation
  -> the two variables are unrelated

Question 12

what does the long run Phillips curve look like?

Answer 12

Question 13

what are the implications of the short run Phillips curve for economic policy?

Answer 13

• if the government tries to decrease unemployment in the short run
  -> there could be inflationary pressure on the price level
  -> in the short run, the economy suffers from demand-deficient unemployment
  -> this might encourage the use of demand side policies to tackle unemployment

Question 14

what are the implications in the long run of the Phillips curve for economic policy?

Answer 14

• changes in the unemployment rate don’t affect the inflation rate
  -> therefore policies can be more flexible since there’s no demand-deficient unemployment in the long run
  -> supply side policies are more likely to be used

Question 15

in the short run, if the government decide to prioritise lower inflation
what can this be at the expense of?

how do you show it on a diagram?

Answer 15

this will be at the expense of unemployment

ie) lowering inflation by increasing taxes which means lower disposable income and therefore lower aggregate demand
- this may cause unemployment to rise

Question 16

what are the trade offs in the long run?

Answer 16

• there’s no trade off in the long run because unemployment returns to the natural rate of unemployment
  (NRU, NAIRU, NRU, YFE)

Question 17

how do you show a positive output gap and its impact on inflation and unemployment using Phillips Curve and Classical LRAS?

Answer 17