Macroeconomic Objectives and Conflicts

The macroeconomic objectives

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The first four are the traditional "big four" and are the most frequently examined; the last three are increasingly prominent.

Conflicts between objectives

The heart of this topic. A policy that advances one objective typically sets back another, and identifying the trade-off precisely is what earns evaluation marks.

1. Growth versus inflation. Raising AD to boost growth pushes output beyond capacity, creating a positive output gap and demand-pull inflation. This is the fundamental short-run trade-off in demand management.

2. Unemployment versus inflation, the Phillips curve. The short-run Phillips curve shows an inverse relationship: lower unemployment means a tighter labour market, so wages and therefore prices rise faster.

1. Unemployment falls below the natural rate
2. labour shortages
3. workers bargain successfully for higher wages
4. firms pass costs on
5. inflation rises.

The long-run Phillips curve is vertical at the natural rate. Once inflation is anticipated, workers demand compensating nominal wage rises, real wages return to their previous level, and unemployment returns to the natural rate at a higher rate of inflation. The trade-off is therefore only available in the short run, and only by surprising people, which is why credible inflation targeting matters so much. Only supply-side policy lowers the natural rate itself.

3. Growth versus the current account. Rising incomes raise imports, so a fast-growing economy typically sees its current account deteriorate.

4. Growth versus the environment. Higher output raises emissions, congestion and resource depletion, negative externalities (5.1).

5. Growth versus equality. Growth can raise inequality if the gains accrue mainly to capital owners and the highly skilled, though it also raises the tax base for redistribution.

6. Unemployment versus the budget. Fiscal stimulus to reduce unemployment widens the deficit; fiscal consolidation to close the deficit raises unemployment.

7. Inflation versus the exchange rate and competitiveness. Raising interest rates to curb inflation attracts capital inflows, appreciating the currency, which damages exporters and worsens the current account.

8. Present versus future. Investment raises future capacity at the cost of present consumption (1.1).

Where objectives are complementary, not conflicting, a point worth making:

• Supply-side policy can raise growth and reduce inflation and reduce unemployment and improve competitiveness simultaneously, because it raises capacity rather than demand.
• Growth raises tax revenue, helping close the deficit.
• Falling unemployment cuts benefit spending and raises tax receipts.

Demand-side and supply-side approaches

The essential division of labour: demand-side policy manages the cycle; supply-side policy raises the trend. Recommending demand stimulus for structural unemployment, or supply-side measures for a demand-deficient recession, is the standard error.

Worked example

An economy has inflation at 6%, unemployment at 3% (below the estimated natural rate of 4.5%), and a widening current account deficit.

The diagnosis:

1. Unemployment below the natural rate and inflation well above target indicate a positive output gap
2. the economy is overheating
3. demand-pull inflation
4. and the strong domestic demand is pulling in imports, worsening the current account.

The demand-side response, raise interest rates:

1. Higher rates raise the cost of borrowing and the return to saving
2. consumption and investment fall
3. AD shifts left
4. the positive output gap closes
5. inflation falls back towards target
6. and weaker domestic demand reduces import volumes, improving the current account.

But note the conflicts this creates:

• Unemployment rises as AD falls, the Phillips curve trade-off, operating in reverse.
• Growth slows, and if the tightening is excessive the economy may be pushed into recession.
• Higher rates attract capital inflows, appreciating the exchange rate → exports become dearer and imports cheaper → this partly offsets the current account improvement, and damages exporters.
• Higher debt-servicing costs squeeze mortgaged households disproportionately, a distributional effect.

The supply-side alternative: investment in skills, infrastructure and competition shifts LRAS right, raising capacity so that the same demand no longer generates inflation, while also improving competitiveness and the current account. It avoids every one of the conflicts above, but it takes years, and does nothing about inflation running at 6% today.

Evaluation.

• The two are complements, not substitutes: monetary tightening addresses the immediate inflation, supply-side reform raises the sustainable growth rate so the problem recurs less often.
• The natural rate is an estimate. If it is actually 3%, the economy is not overheating and tightening would be a serious error.
• Time lags in monetary policy are roughly 18 months to full effect, so the tightening bites after the situation has already changed.
• If the inflation is partly cost-push in origin, raising rates reduces output without addressing the cause.

Judgement: with clear evidence of a positive output gap, monetary tightening is the correct immediate instrument despite the unemployment and exchange rate costs, and it should be paired with supply-side reform to raise the capacity ceiling that caused the conflict in the first place.

Common exam mistakes

• Listing objectives without identifying a conflict between them.
• Drawing the long-run Phillips curve as downward-sloping; it is vertical at the natural rate.
• Saying the Phillips curve trade-off is permanently exploitable; it holds only in the short run.
• Recommending demand-side policy for structural unemployment.
• Forgetting that supply-side policy can achieve several objectives simultaneously, the strongest complementarity point available.
• Ignoring the exchange rate effect of interest rate changes.

Exam technique

Diagnose before prescribing. Identify the output gap and the type of unemployment or inflation from the data, then choose the instrument. Answers that recommend a policy before diagnosing the problem lose the analysis marks.

Name the specific conflict and explain its mechanism, "reducing unemployment tightens the labour market, so wage growth accelerates and inflation rises" beats "there is a trade-off".

Conclude by noting that supply-side policy relaxes several conflicts at once but works only over years, so it complements rather than replaces demand management. That structure answers most 25-markers in this section.

Quick revision

• Objectives: growth, 2% inflation, low unemployment, balance of payments, plus the budget, equity and sustainability.
• Conflicts: growth vs inflation; unemployment vs inflation (Phillips curve); growth vs the current account; growth vs the environment; growth vs equality; unemployment vs the budget; inflation vs competitiveness.
• Short-run Phillips curve slopes down; the long-run Phillips curve is vertical at the natural rate.
• Only supply-side policy lowers the natural rate.
• Demand-side policy (fiscal, monetary) manages the cycle and cyclical unemployment.
• Supply-side policy raises LRAS and the trend, tackling structural unemployment.
• Supply-side policy can achieve growth, low inflation, low unemployment and competitiveness together, but takes years.

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