Conflicting Objectives

Question 1

What are some macroeconomic trade-offs?

Answer 1

• Econ growth and inflation
• Econ growth and BOP on current account
• Econ growth and inequality
• Unemployment and inflation in the SR (Phillips)
• Reducing gov. borrowing and the national debt and growth + living standards
• Unemployment and gov. debt- higher benefit spending
• Econ growth and environment

Question 2

What is the Short-Run Phillips Curve?

Answer 2

The Short-Run Phillips Curve is a graphical representation showing the inverse relationship between inflation and unemployment in the short run. It suggests that when unemployment is low, inflation tends to be high, and vice versa.

Question 3

What is the basic relationship shown by the Short-Run Phillips Curve?

Answer 3

The Short-Run Phillips Curve shows an inverse (negative) relationship between inflation and unemployment. As unemployment decreases, inflation increases, and as unemployment increases, inflation decreases.

Question 4

What does a movement along the Short-Run Phillips Curve represent?

Answer 4

A movement along the curve represents a trade-off between inflation and unemployment.

Question 5

How does demand-pull inflation explain the Short-Run Phillips Curve?

Answer 5

When aggregate demand increases, firms hire more workers (lowering unemployment) and raise prices due to increased demand due to more people with disposable income to spend (causing inflation). This creates the inverse relationship: lower unemployment comes with higher inflation.

Question 6

How does cost-push inflation relate to the Short-Run Phillips Curve?

Answer 6

When wages rise due to tight labour markets (low unemployment means firms have to raise wages to attract more workers), firms face higher production costs and pass these on as higher prices (inflation).

Question 7

What happens to the economy when it moves to the left along the Short-Run Phillips Curve?

Answer 7

Moving to the left means unemployment is decreasing while inflation is increasing. This typically occurs during economic expansions when aggregate demand is rising.

Question 8

What happens to the economy when it moves to the right along the Short-Run Phillips Curve?

Answer 8

Moving to the right means unemployment is increasing while inflation is decreasing. This typically occurs during economic contractions or recessions when aggregate demand is falling.

Question 9

How can you illustrate the Short-Run Phillips Curve using an AS/AD diagram?

Answer 9

An increase in aggregate demand (AD shifts right) causes both higher price levels (inflation) and higher output (lower unemployment), showing the inverse relationship. A decrease in AD (shift left) causes lower prices and higher unemployment.

Question 10

In which decade did the Short-Run Phillips Curve relationship start to break down?

Answer 10

The relationship started to break down in the 1970s during the period of stagflation, when both high inflation and high unemployment occurred simultaneously.

Question 11

What is stagflation and how does it challenge the Phillips Curve?

Answer 11

Stagflation is the simultaneous occurrence of high inflation and high unemployment. This contradicts the Short-Run Phillips Curve’s prediction of an inverse relationship between the two variables.

Question 12

What causes a shift in the Short-Run Phillips Curve?

Answer 12

Changes in inflation expectations, supply shocks increasing costs (like oil price increases), or changes in the natural rate of unemployment (increases in the NAIRU allowing for a higher unemployment rate without the risk of inflation.

Question 13

What is the policy implications of the Short-Run Phillips Curve?

Answer 13

The curve suggests policymakers face a trade-off: they can use expansionary policy to reduce unemployment but will cause higher inflation, or use contractionary policy to reduce inflation but will cause higher unemployment.

Question 14

Why might the Short-Run Phillips Curve be vertical in the long run?

Answer 14

In the long run, the economy returns to its natural rate of unemployment regardless of the inflation rate, making the Long-Run Phillips Curve vertical. This is because inflation expectations adjust over time.

Question 15

What role do inflation expectations play in the Phillips Curve?

Answer 15

When workers and firms expect higher inflation, they build this into wage and price decisions, shifting the Short-Run Phillips Curve upward. This can break the traditional inverse relationship.

Question 16

How does expansionary monetary policy affect the Short-Run Phillips Curve?

Answer 16

Expansionary monetary policy (lowering interest rates, increasing money supply) moves the economy down along the Short-Run Phillips Curve, decreasing unemployment but increasing inflation.

Question 17

How does contractionary monetary policy affect the Short-Run Phillips Curve?

Answer 17

Contractionary monetary policy (raising interest rates, decreasing money supply) moves the economy up along the Short-Run Phillips Curve, decreasing inflation but increasing unemployment.

Question 18

How does a negative supply shock affect the Phillips Curve?

Answer 18

A negative supply shock (like an oil price increase) shifts the Short-Run Phillips Curve to the right, causing both higher inflation and higher unemployment simultaneously (stagflation).

Question 19

What is the difference between the Short-Run and Long-Run Phillips Curve?

Answer 19

The Short-Run Phillips Curve is downward sloping, showing an inverse relationship between inflation and unemployment. The Long-Run Phillips Curve is vertical at the natural rate of unemployment, showing no trade-off exists in the long run.

Question 20

What is the Long-Run Phillips Curve (LRPC)?

Answer 20

The Long-Run Phillips Curve is a vertical line at the natural rate of unemployment. It shows that in the long run, there is no trade-off between inflation and unemployment - the economy will always return to the natural rate of unemployment regardless of the inflation rate.

Question 21

Who developed the expectations-augmented Phillips Curve?

Answer 21

Milton Friedman developed the expectations-augmented Phillips Curve, which explains why the Phillips Curve relationship breaks down in the long run when inflation expectations adjust.

Question 22

What are the initial economic conditions at point A?

Answer 22

Point A represents the economy at 0% inflation, full employment, and the natural level of unemployment. This is the long-run equilibrium with stable prices and no inflation expectations.

Question 23

Why does the government attempt to move from point A to point B?

Answer 23

The government attempts to reduce the natural level of unemployment by stimulating aggregate demand. This represents an expansionary policy designed to create more jobs and lower unemployment below its natural rate.

Question 24

What must happen to real wages for unemployment to fall below the natural rate?

Answer 24

Real wages must increase to persuade some of the natural level unemployed to accept jobs. The increase in aggregate demand (from increased G) creates higher demand for labour, which pushes real wages up and entices workers into the labor market.

Question 25

What is point B on the expectations-augmented Phillips Curve?

Answer 25

Point B represents a temporary situation where unemployment has fallen below the natural rate but inflation has risen. This shows the short-run trade-off between inflation and unemployment.

Question 26

What is 'money illusion'?

Answer 26

Money illusion occurs when workers focus on nominal (money) wage increases rather than real wages. Workers initially accept jobs because they see higher money wages, not realizing that inflation is reducing their purchasing power.

Question 27

Why do workers initially accept jobs at point B?

Answer 27

Workers accept jobs because they experience money illusion - they see nominal wage increases and don't immediately realize that the inflation caused by increased aggregate demand is eroding the real value of their wages.

Question 28

What happens when workers stop suffering from money illusion?

Answer 28

Once workers realize their real wages have fallen due to inflation, they leave the labour market again. This begins the process of unemployment rising back toward the natural rate.

Question 29

If nothing else changed after workers left the labour market, where would the economy return to?

Answer 29

If nothing else changed, the market would return to point A - back to the natural rate of unemployment with 0% inflation. However, this doesn't happen because inflation has affected all workers in the economy.

Question 30

How does inflation affect workers who were already employed at full employment?

Answer 30

Inflation reduces the real wages of those who were already in work at full employment. These workers also suffer from money illusion initially but eventually realize their purchasing power has declined.

Question 31

What do existing workers demand once they stop suffering from money illusion?

Answer 31

Existing workers demand a pay increase to restore the value of their real wages. This represents workers adjusting their wage demands based on their experience of inflation.

Question 32

What are inflation expectations?

Answer 32

Inflation expectations are the beliefs that workers and firms hold about future inflation rates. When workers have experienced inflation, they build expectations of future inflation into their wage demands to protect their real wages.

Question 33

How do inflation expectations spread across the economy?

Answer 33

Across the economy, all workers build expectations of inflation into their wage demands. This becomes a widespread phenomenon as everyone adjusts their behavior based on the inflation they've experienced- all workers will have experienced the inflation.

Question 34

What happens when firms give workers pay increases to match inflation expectations?

Answer 34

Firms give their workers pay increases and then increase prices to cover the increase in costs. This creates a wage-price spiral where higher wages lead to higher prices, which lead to further wage demands.

Question 35

What represents point C on the diagram?

Answer 35

Point C represents the economy returning to full employment (natural rate of unemployment) but with persistent inflation. The economy is back at the same unemployment level as point A but now has ongoing inflation built into expectations.

Question 36

What causes persistent inflation at point C?

Answer 36

Persistent inflation is caused by the **cycle of pay increases leading to price increases**, which lead to further pay increases. This cycle is driven by workers and firms having built inflation expectations into their decision-making.

Question 37

How has the Short-Run Phillips Curve shifted from point A to point C?

Answer 37

The Short-Run Phillips Curve has shifted upward due to higher inflation expectations. The economy is on a new SRPC that reflects the expected inflation rate, which is why it can be at the natural rate of unemployment with higher inflation.

Question 38

According to the theory, how can the government reduce inflation?

Answer 38

The government must reduce aggregate demand, which leads to unemployment rising above the natural rate. This contractionary policy is necessary to break the cycle of inflation expectations.

Question 39

What must workers accept for the economy to return to lower inflation?

Answer 39

Workers must accept real pay cuts. As unemployment rises and labour market conditions weaken, workers eventually accept lower wage growth, which allows firms to reduce price increases.

Question 40

What happens after workers accept real pay cuts and inflation falls?

Answer 40

The economy returns to full employment with a lower inflation rate and lower expectations of future inflation. This moves the economy back toward the natural rate but on a lower Short-Run Phillips Curve.

Question 41

Why is the Long-Run Phillips Curve vertical?

Answer 41

The LRPC is vertical because any attempt to maintain unemployment below the natural rate only results in higher inflation expectations. Once expectations adjust, unemployment returns to the natural rate regardless of the inflation level.

Question 42

Can demand management policies permanently reduce the natural level of unemployment?

Answer 42

No, demand management policies cannot permanently reduce the natural level of unemployment. They only create temporary reductions in unemployment at the cost of higher inflation in the long run.

Question 43

What is the only way to reduce the natural level of unemployment in the long run?

Answer 43

The government can only reduce the natural level of unemployment by adopting successful supply-side policies. These policies shift the Long-Run Aggregate Supply (LRAS) to the right and the LRPC to the left.

Question 44

What are examples of supply-side policies that could reduce the natural rate?

Answer 44

Supply-side policies include improving education and training, reducing labor market rigidities, decreasing unemployment benefits (to reduce voluntary unemployment), improving job matching services, and reducing barriers to work.

Question 45

What is the main lesson of the expectations-augmented Phillips Curve?

Answer 45

The main lesson is that attempts to reduce unemployment below the natural rate using demand management will simply lead to higher inflation in the long run with no permanent reduction in the natural level of unemployment.

Question 46

What is the wage-price spiral?

Answer 46

The wage-price spiral is a self-reinforcing cycle where workers demand higher wages to compensate for inflation, firms raise prices to cover higher wage costs, which leads to more inflation and further wage demands.

Question 47

How do inflation expectations affect the position of the Short-Run Phillips Curve?

Answer 47

Higher inflation expectations shift the Short-Run Phillips Curve upward (right). Each SRPC corresponds to a specific expected inflation rate - when expectations rise, the entire curve shifts up.

Question 48

What is the relationship between the natural rate of unemployment and the LRPC?

Answer 48

The LRPC is always located at the natural rate of unemployment. This vertical line shows that in long-run equilibrium, unemployment will always return to this natural rate regardless of inflation policy.

Question 49

Why can't the government maintain unemployment at point B permanently?

Answer 49

The government cannot maintain unemployment at point B because workers eventually recognize that inflation has eroded their real wages. Once they stop suffering from money illusion and adjust their expectations, they demand higher wages, which pushes unemployment back to the natural rate.

Question 50

What determines the position of the Long-Run Phillips Curve?

Answer 50

The position of the LRPC is determined by the **natural rate** of unemployment, which depends on **structural factors** like labor market flexibility, skills, job matching efficiency, and the level of frictional and structural unemployment.

Question 51

How does reducing aggregate demand help lower inflation expectations?

Answer 51

Reducing aggregate demand creates unemployment above the natural rate, which weakens workers' bargaining power. This forces workers to accept lower wage increases, breaking the wage-price spiral and gradually reducing inflation expectations.

Question 52

What is the difference between a movement along the SRPC and a shift of the SRPC?

Answer 52

A movement along the SRPC represents a change in actual unemployment and inflation while expectations remain constant. A shift of the SRPC occurs when inflation expectations change, creating a new trade-off curve at a different expected inflation level.

Question 53

Why is it difficult to reduce inflation once expectations are established?

Answer 53

Once inflation expectations are established, they become **self-fulfilling**. Workers demand wage increases expecting inflation, firms raise prices to cover costs, and actual inflation matches expectations. Breaking this cycle requires painful unemployment above the natural rate.

Question 54

What role does credibility play in fighting inflation?

Answer 54

If the government has credibility, workers may lower their inflation expectations more quickly, allowing inflation to fall without as much unemployment. Without credibility, workers won't believe inflation will fall and will maintain high wage demands longer.

Question 55

Has the Phillips Curve relationship broken down?

Answer 55

Yes, significantly. Evidence shows the inverse relationship no longer holds - unemployment can fall to historic lows without causing wage or inflation pressure. UK and US data show wages stuck around 2% despite very low unemployment.

Question 56

Why did the Phillips Curve work in the 1950s-60s but not now?

Answer 56

In the 1950s-60s, the relationship was clear and policymakers could trade off unemployment for inflation. Since 1970s stagflation, the curve has flattened due to globalisation, weaker unions, changed expectations, and structural economic changes.

Question 57

What is the 'flattening' of the Phillips Curve?

Answer 57

The curve has become much flatter or horizontal, meaning large unemployment changes cause minimal inflation changes. This makes the traditional trade-off between unemployment and inflation much weaker or non-existent.

Question 58

What does a 'downward shift' in the Phillips Curve mean?

Answer 58

Lower inflation expectations and structural changes mean the economy can operate at lower unemployment levels without generating inflation. The whole curve shifts down to a more favorable position.

Question 59

How do inflation expectations affect the Phillips Curve?

Answer 59

When expectations are anchored at low levels (like 2%), workers don't demand large wage increases even when unemployment is low. This prevents the wage-price spiral that the traditional Phillips Curve predicted.

Question 60

What role does globalisation play in the Phillips Curve breakdown?

Answer 60

Globalisation increases competition and constrains firms' pricing power. Even with low domestic unemployment, firms face global competition that limits their ability to raise prices, breaking the traditional relationship.

Question 61

What is the policy dilemma created by the flat Phillips Curve?

Answer 61

Central banks struggle to know when to raise rates. With unemployment very low but no inflation pressure, traditional models provide little guidance. Also, policymakers face uncertainty about when wage pressure might suddenly appear.

Question 62

Why is low inflation desirable?

Answer 62

- High inflation erodes living standards, leads to uncertainty - Low inflation contributes to a predictable economic environment, which allows households and firms to plan effectively for the future. - Stable, low inflation encourages firms to invest in productive capacity, which can lead to higher economic growth over time. - A moderate inflation rate helps maintain a country’s international competitiveness.

Question 63

Why is full employment desirable?

Answer 63

- Provides job security and avoids the costs of unemployment - Not reaching productive - It allows the economy to grow more efficiently, as all resources are utilized to their fullest potential. - Less gov. spending on unemployment benefits and more tax revenue

Question 64

Why is economic growth desirable?

Answer 64

- Leads to higher incomes leading to improved living standards and quality of life improving welfare of individuals- reduces poverty if relatively equal growth. - Better job opportunities - Generates more gov revenue through tax and less spending on benefits are more employment from firms willing to expand.

Question 65

Why is environmental sustainability desirable?

Answer 65

- Economic and social costs of poor environment - Long term benefit to future generations. - minimize resource depletion, reduce pollution, promote conservation, and ensure the efficient use of our planet’s natural resources.

Question 66

Why is a stable balance of payments desirable?

Answer 66

- Indicates a country's financial health and sustainability. - It helps to avoid economic crises by maintaining flexibility and maintain a stable currency value. currency value. - Signals confidence to foreign investors allowing for FDI. - A balanced BOP ensures that a country can meet its external obligations without resorting to emergency measures.

Question 67

Why is a balanced budget desirable?

Answer 67

- Demonstrates a government's commitment to fiscal stability, enhancing investor confidence and trust in the economy. - Reduces gov. debt, lower opportunity cost of debt repayments and avoids crowding out. - Flexibility during economic downturns: It allows a government to have greater fiscal flexibility, providing room for potential stimulus measures to mitigate the impact of a recession.

Question 68

What are some possible policy solutions to the inflation/ unemployment trade off (SR Philips curve)?

Answer 68

- SS policies Aim to lower the natural rate of unemployment by improving labour market flexibility, education, and training. Encourage productivity growth and shift the long-run aggregate supply (LRAS) outward, allowing growth without inflationary pressure. - increasing incentives to work through better job matching, and subsidised training and education and bringing in skilled migration. - Subsidising childcare and transport to improve labour mobility.

Question 69

What is some evaluation to possible policy solutions to the inflation/ unemployment trade off (SR Philips curve)?

Answer 69

- Trade-off seemingly flawed- stagflation in the 1970s, flattening of the Philips curve - SR Philips curve could shift out if expectations of inflation change- LR Philips curve explain.. unemployment settles at the natural rate (NAIRU) in the long run. - Labour market changing the nature of employment- TU falling power, gig economy and more flexible labour market. - Weak wage pressure already exists and there is a tight labour market from weak productivity/ lack of skills- more job vacancies than available qualified workers - Attempts to maintain unemployment below the natural rate of unemployment (also known as the NAIRU — non-accelerating inflation rate of unemployment) will only cause accelerating inflation. -Monetary and fiscal policy cannot permanently lower unemployment below the natural rate. - Thus sustainable growth in output and employment requires supply-side policies, not demand stimulation.

Question 70

What are some possible policy solutions to address the growth/ environment trade off?

Answer 70

- Government investment into sustainable growth e.g. renewable energy which creates jobs and economic activity, UK Wind Farms - Carbon tax - Carbon credits- incentive to invest in transitioning in the LR as can sell excess credits for revenue. - Subsidies to incentivise transition Long run growth

Question 71

What is some evaluation to possible policy solutions to the growth/ environment trade off?

Answer 71

- May just be an unavoidable cost of economic growth. - Developed nations in the past have all polluted in order - Carbon taxes may increase costs for businesses and slow down economic growth as a result

Question 72

What are some possible policy solutions to the growth/ BoP trade off?

Answer 72

- Strengthen domestic competitiveness and increase productivity through SS investment. - Increasing demand for exports whilst boosting SR + LR growth - Depreciate the currency- SPICED

Question 73

What is some evaluation to possible policy solutions to the growth/ BoP trade off?

Answer 73

- Takes time to improve domestic competitiveness e.g. chronic productivity problems - Depreciation just masks domestic inefficiencies - Risk of imported inflation which hurts growth

Question 74

What are some possible policy solutions to the growth/ inequality trade off?

Answer 74

SS policy - Invest in education and training to reduce skills gaps and improve economic outcomes for all - Improving job quality - More progressive tax systems, higher MPC of lower incomes may actually lead to more growth from higher consumption

Question 75

What is some evaluation to possible policy solutions to the growth/ inequality trade off?

Answer 75

- Feature of capitalist system, winner and loser, market needs incentives to operate efficiently- inequality provides incentives - Trickle down..

Question 76

What are some possible policy solutions to the unemployment/ balanced budget trade off?

Answer 76

SS policy, can increase employment leading to economic growth and can be self financing if add to GDP/ create jobs for tax revenue - Flexible labour market may lead to increase mobility of labour.

Question 77

What is some evaluation to possible policy solutions to the unemployment/ balanced budget trade off?

Answer 77

- Long run policy so may take time to take effect - Flexible labour market may lead to poorer working conditions affecting living standards and increase inequality as the poorest are often the members of the flexible labour market/ gig economy.

Question 78

What do monetarists and SS economists argue about conflicting objectives?

Answer 78

that although short-run conflicts exist between macroeconomic objectives, in the long run these conflicts diminish. They argue that market mechanisms, stable monetary policy, and structural reforms allow the economy to achieve non-inflationary growth, low unemployment, and stable prices simultaneously.

Question 79

How do the key principles of monetarism relate to conflicting objectives?

Answer 79

Monetarism emphasises the importance of controlling the money supply to maintain price stability. Monetarists believe that inflation is primarily caused by excessive monetary growth. In this view, if monetary growth is controlled, inflationary pressures subside, creating conditions in which other objectives can be pursued without conflict. BUT many argue that inflation is influenced by many factors not just monetary growth.