Conflicts Between Macroeconomic Policy Objectives (AQA A-Level Economics): Revision Notes

Conflicts Between Macroeconomic Policy Objectives

Introduction to policy conflicts

When governments set economic goals, they often discover that achieving one objective can make it harder to achieve another. This creates what economists call policy conflicts or policy trade-offs. Understanding these conflicts is crucial because governments must make difficult choices about which objectives to prioritise.

UK macroeconomic policy has historically faced four significant short-run conflicts:

• Balancing full employment and economic growth against maintaining a healthy balance of payments
• Achieving low unemployment whilst also controlling inflation
• Promoting economic growth whilst also ensuring fairer income and wealth distribution
• Raising living standards now versus saving for higher living standards in the future

The first conflict relates to external objectives (international trade), whilst the others involve internal domestic goals. These conflicts are particularly important in the short run, though some can persist over longer periods.

Understanding trade-offs between objectives

Because macroeconomic objectives can be mutually exclusive (achieving one prevents achieving another), governments cannot accomplish everything simultaneously, at least not in the short term. This forces policymakers to make compromises.

For example, a government might accept relatively low unemployment alongside relatively low inflation, recognising that achieving both full employment and complete price stability together is impossible. This represents a trade-off where the government chooses an acceptable balance between two competing goals.

Governments may also change their priorities over time. For instance, a government might focus on reducing unemployment in the months before an election to win votes, knowing that if elected, they may need to switch focus to controlling inflation afterwards.

Recent policy dilemmas

In 2022, the UK government and Bank of England faced a particularly challenging situation. With rising inflation and falling economic growth, what should happen to interest rates?

Higher interest rates would likely reduce economic growth further and possibly push the UK into recession. However, leaving interest rates at their 2021 level (or only increasing them slightly) risked the cost-push inflation of 2022 becoming a more serious long-term problem if inflationary expectations became entrenched, potentially creating a wage-price inflationary spiral. A former Bank of England governor described this as the Bank facing a 'narrow path' to avoid recession.

How negative and positive output gaps relate to unemployment and inflationary pressures

Understanding output gaps is essential for grasping policy conflicts. An output gap measures the difference between an economy's actual output and its potential (trend) output.

The diagram above shows two scenarios:

• The upper panel displays a volatile economic cycle, where actual output swings dramatically above and below the trend growth line
• The lower panel shows a smoother, more stable economic cycle with smaller fluctuations

A positive output gap occurs when actual output exceeds trend output (shown by red bars). This typically happens during economic booms and is associated with:

• Low unemployment
• Rising inflationary pressures
• Economy operating above its sustainable capacity

A negative output gap occurs when actual output falls below trend output (shown by blue bars). This typically happens during recessions and is associated with:

• High unemployment
• Low inflationary pressures
• Unused capacity in the economy

Policy conflicts and the Phillips curve

The short-run Phillips curve

The debate about whether inflation is primarily caused by demand-pull or cost-push factors is sometimes examined using a statistical relationship called the Phillips curve.

Key term: The Phillips curve is based on evidence from the economy showing the apparent relationship between the rate of inflation and the rate of unemployment, now known as the 'short-run Phillips curve'.

The Phillips curve is named after the Keynesian economist A.W. Phillips, who in the mid-20th century observed that statistical evidence showed an inverse relationship between the rate of wage inflation and the percentage of the labour force unemployed over nearly a century. Later versions of the Phillips curve measure the inverse relationship between unemployment and the rate of price inflation.

Whilst the Phillips curve represents a statistical relationship between two variables rather than a theory of inflation itself, both demand-pull and cost-push theories can explain this relationship:

Demand-pull explanation: The factor causing unemployment to fall and movement up the Phillips curve is excess demand. This pulls up money wages and the average price level.

Cost-push explanation: Falling unemployment means trade union power increases, enabling unions to use their growing monopoly power over the labour supply to push for higher wages.

The Phillips curve as a policy menu

The statistical evidence shown in the Phillips curve illustrates the conflict between full employment and controlling inflation as policy objectives. It also suggests how this conflict might be addressed.

Suppose unemployment initially sits at $U_1$ with an inflation rate of $P_1$, placing the economy at point A on the Phillips curve. By increasing aggregate demand, the government can move the economy to point B. The unemployment rate falls to $U_2$, but this comes at the cost of a higher inflation rate at $P_2$.

Using demand management policies, it appears possible for governments to trade off between increasing employment in the economy and reducing inflation. Points such as A and B on the Phillips curve represent a menu of choice for governments when deciding an acceptable combination of unemployment and inflation.

The long-run Phillips curve

Modern economists generally recognise that the Phillips curve shown previously represents a short-run Phillips curve (SRPC), depicting the short-run relationship between inflation and unemployment.

A vertical long-run Phillips curve (LRPC) has been added to the analysis, intersecting the short-run Phillips curve where the inflation rate is zero. The unemployment rate at this point is the natural rate of unemployment (NRU), shown by the symbol $U_N$. (When expressed as the unemployment level rather than rate, it's called the natural level of unemployment.)

Free-market economists argue that reducing unemployment below the natural level is impossible, except at the cost of suffering an ever-accelerating and unanticipated inflation rate. This would likely accelerate into hyperinflation, causing severe damage to the economy.

The role of supply-side policies

According to free-market economists, the immediate solution is for government to respond to its mistake of trying to keep unemployment below its natural level by reducing aggregate demand to take unemployment back to its natural level.

However, the long-term solution is to reduce the natural level itself. This can be achieved by implementing appropriate supply-side policies (discussed in Chapter 13), which shift the long-run Phillips curve to the left. When the curve shifts from $\text{LRPC}_1$ to $\text{LRPC}_2$, the natural rate of unemployment falls from $U_{N1}$ to $U_{N2}$.

Understanding shifts in short-run Phillips curves

The complete Phillips curve model shows multiple short-run Phillips curves ($\text{SRPC}_1$, $\text{SRPC}_2$, $\text{SRPC}_3$) alongside the vertical long-run Phillips curve (LRPC). Each short-run curve represents a different expected rate of inflation.

When workers and firms continuously adjust their expectations of future inflation to match the rising actual rate and bargain for ever-higher money wages, the short-run Phillips curve shifts outwards. The curve moves from $\text{SRPC}_1$ to $\text{SRPC}_2$ and so on. Indeed, there exists a separate short-run Phillips curve for each expected rate of inflation.

'Further-out' short-run Phillips curves such as $\text{SRPC}_2$ and $\text{SRPC}_3$ are associated with higher expected rates of future inflation. Conversely, the short-run Phillips curve shifts inwards when the expected rate of inflation falls.

Free-market economists contend that in the long run, the only way to keep unemployment below its natural level is to permit the money supply to expand and finance an ever-accelerating rate of inflation. Actual inflation must always exceed the expected rate for workers and firms to be willing respectively to supply and demand more labour.

Stabilising inflation expectations

If government realises it made a mistake when expanding the economy to point B, it can stabilise the inflation rate at 5%. Workers and employers 'see through' their money illusion and realise they have confused money quantities with real quantities. Once this happens, they refuse respectively to supply and demand the labour necessary to keep unemployment below its natural level. The economy moves to point C.

Key lessons from the Phillips curve analysis

Pro-free-market economists generally believe that successful supply-side policies, combined with supply-side reform in the private sector, facilitate the production of high-quality goods and services which people in the UK and abroad wish to buy. They cite the recent success of car manufacturing in the UK as evidence. According to this supply-side view, sustained economic growth in the long run resolves short-run conflicts between policy objectives. The supply-side approach to economic policy is examined thoroughly in Chapter 13.

Reconciling possible policy conflicts in the short run and the long run

In the short run, policy conflicts between reducing unemployment and achieving price stability might be reconciled in a highly depressed economy where output is well below its normal capacity, as illustrated on a Keynesian AS curve.

However, if the economy is initially producing on its vertical LRAS curve (or on the vertical section of a Keynesian AS curve) with unemployment at its natural level, short-run reconciliation is no longer possible. Instead, government should try to improve supply-side conditions in the economy in the hope of increasing labour productivity and making the economy more competitive in world markets.