2.6.4 Conflicts and trade-offs between objectives and policies

Question 1

What are potential conflicts between objectives?

Answer 1

1. Unemployment and inflation (price stability) - Phillips Curve analysis is used for this trade-off
2. Economic growth and inflation – an overheating economy with excess AD can see accelerating demand-pull
   inflation
3. Economic growth and the balance of payments – a consumer boom may cause the trade deficit to rise as
   demand for and spending on imports grows faster than income from exports
4. Economic Growth and Inequality – the benefits from economic growth are not evenly distributed
5. Per capita income vs environmental degradation - rapid growth might lead to increased pollution, waste and
   long-term damage to the stock of natural resources (natural capital)
6. Income inequality vs Economic growth - does high inequality causes slower long-term growth?

Question 2

How might there be potential conflict between economic growth and inflation?

Answer 2

o The risk of accelerating inflation is greatest when aggregate supply is inelastic i.e. when the economy has low
spare capacity
o If an economy suffers high inflation and a slowdown in economic growth – this is called stagflation
o The conflict between growth and inflation can be resolved by having effective supply-side policies

Question 3

Describe the trade off between eg and inflation

Answer 3

This diagram shows the worsening trade-off between economic growth and inflation. An outward shift in AD from AD3 to AD4 causes a sharp rise in the general price level because AS is inelastic (i.e. output is close to full-capacity levels).

Question 4

How can there be a potential trade off between economic growth and the balance of payments?

Answer 4

Question 5

Give measures to overcome the trade off between economic growth and BoP

Answer 5

• Supply-Side Policies
  o Reforms to improve labour productivity
  o Incentives to promote research & development & innovation
  o Measures to increase investment in export sectors
• Exchange Rate Depreciation
  o A depreciation of the currency (in theory) makes exports more price competitive and imports are more expensive
  o But the effects are dependent on price elasticity of demand for exports and imports
• Sound / Effective Macroeconomic Policies
  o Monetary policy to keep inflation low relative to the inflation of major trading competitor countries
  o Infrastructure investment to increase export competitiveness

Question 6

What are the effects of a potential trade-off between economic growth and the stock of environmental assets?

Answer 6

Question 7

What is the Phillips Curve?

Answer 7

The Phillips Curve shows a trade-off between inflation and unemployment. A demand-side policy to reduce
unemployment could conflict with price stability.
It suggested an inverse relationship between the rate of unemployment and the percentage change in wages

Question 8

What does the Phillips Curve look like?

Answer 8

Question 9

Explain the elastic part of the Phillips Curve

Answer 9

• When the unemployment rate is high, wage pressures in the labour market are likely to be low – workers have
  little relative bargaining power because they can be easily replaced by someone willing to work at a lower
  wage
• There is plenty of spare capacity in the labour market such as many unfilled jobs vacancies
• Fears over job security might also lead to workers being unwilling to bid for higher wages

Question 10

Explain the inelastic part of the Phillips Curve

Answer 10

• As unemployment falls, labour shortages may cause an increase in wage inflation and higher unit labour costs
• When an economy is booming, so does the derived demand for and prices of components and raw materials
  – leading to higher costs
• Rising demand and falling unemployment can lead to suppliers raising prices to increase their profit margins
• Workers have relatively more bargaining power, because they are a scarce resource and in demand by firms

Question 11

What is the natural rate of unemployment?

Answer 11

• The natural rate of unemployment is also known as the equilibrium rate of unemployment
• It is estimated by adding to together frictional + structural unemployment

Question 12

What supply side policies can help to decrease the natural rate of unemployment?

Answer 12

• Improve the occupational mobility of labour force
• Attract more people into an active search for work
• Reduce the problem of occupational immobility
• Lift labour productivity

Question 13

Why might there have been an improved trade-off between unemployment and inflation?

Answer 13

1. Improved labour mobility and incentives
2. Impact of skilled migration into the labour market
3. Reduced worker bargaining power / rise of monopsony employers
4. Effects of globalisation / technological change on consumer prices