Chapter 33 - The Phillips curve and policy conflicts Flashcards
What is a trade-off?
When a gain in one item must be accompanied by a loss in some other item.
What is the Phillips curve?
An empirical relationship suggesting that there is a trade-off between unemployment and inflation
What is stagflation?
A situation describing an economy in which both unemployment and inflation are high at the same time
What is the natural rate of unemployment?
In discussing the AD/AS model, it was argued that there was a full employment level of real GDP, sometimes known as the natural rate of output. Under neoclassical assumptions, the economy would always adjust to this level of real GDP, so that the long-run aggregate supply (LRAS) curve would be vertical at this full employment level. Corresponding to this full employment level of real GDP is a rate of unemployment, which has become known as the natural rate of unemployment. This is the rate of unemployment in which there is only frictional and structural unemployment, as real wages will have adjusted to the equilibrium level.
What is the non-accelerating inflation rate of unemployment (NAIRU)?
The rate of unemployment in an economy that is consistent with a constant rate of inflation, equivalent to the natural rate of unemployment
What is the long-run Phillips curve?
The long-run relationship between unemployment and inflation, which is vertical at the natural rate of unemployment under neoclassical assumptions
What are adaptive expectations about the economy?
Notice that an important assumption here is that economic agents base their behaviour on expectations about the future course of the economy. But how do they form these expectations?
One possibility is that expectations are formed based on the past performance of the economy. Economic agents observe the economy in one period, and then adapt to that when forming expectations about the future. This is known as adaptive expectations. Their expectations are shaped by the past.
The neoclassical economists rejected this view, arguing that economic agents would always take decisions on the basis of all the information available. In other words, they would not simply assume that the economy would behave consistently with past experience. Instead they would use all of the information available, understanding how the economy operates and avoiding systematic errors. For example, they would have as good an information set as the government and would therefore be able to predict how the government would react to changes in the economy. This theory is known as rational expectations, and helps to explain how it is that the economy will reach its equilibrium so rapidly.
What is the relationship between the Phillips curve and the macroeconomic policy?
How important is the Phillips curve for the design of macroeconomic policy? When policy-makers first came across the trade-off between unemployment and inflation, it became tempting to exploit the trade-off for electoral purposes. It seemed possible to expand the economy in the run-up to an election, getting unemployment to fall and creating a feel- good factor, while allowing inflation to creep up, ready to be brought back down after the election. This is clearly not helpful for the economy in the long run.
The disappearance of the Phillips curve in the 1970s put a damper on this approach, and it became apparent that the cost of bringing inflation back under control was high.
Some commentators argued that the Phillips curve (even if it did exist) could not be used for short-term political expediency because, once economic agents realised what the government was doing, they would factor it into their expectations formation process, and would therefore discount the government’s attempts to manipulate the economy. If the neoclassical economists were correct, trying to affect the natural rate was doomed to failure.
This parallels the discussion of discretionary fiscal policy, which has been criticised on the grounds that trying to manipulate aggregate demand would be futile because the economy would always return to its equilibrium. Under neoclassical assumptions, this adjustment would be rapid.
What are the key objectives of macroeconomic policy?
- economic growth
- full employment
- low inflation
- stability in the balance of payments
- an acceptable distribution of income
- a balanced government budget
- protection of the environment
What are the conflicts and trade-offs of unemployment and inflation?
If the Phillips curve relationship holds, attempts to reduce the rate of unemployment are likely to raise inflation. On the other hand, a reduction in inflation is likely to result in higher unemployment. This suggests that it might be difficult to maintain full employment and low inflation at the same time. Indeed, attempting to achieve economic growth when the economy is already at full employment could lead to inflation.
This is an example of where policy-makers need to be aware of the trade-off between these objectives when designing the mix of macroeconomic policy, and be aware of the dangers of trying to exploit the trade-off.
This trade-off between unemployment and inflation is by no means the only example.
What are the conflicts and trade-offs of economic growth and the current account of the balance of payments?
In some circumstances, conflict can arise between achieving economic growth and attaining equilibrium on the current account of the balance of payments. An increase in economic growth resulting in higher real incomes could lead to an increase in imports of goods and services, if UK residents spend a high proportion of their additional income abroad. This was seen as a major problem during the fixed exchange rate era of the 1950s and 1960s, when any deficit on the current account had to be met by running down foreign exchange reserves. This led to a ‘stop-go’ cycle of macroeconomic policy, where every time growth began to accelerate, the current account went into deficit, and policy then had to be adjusted to slow down the growth rate to deal with the deficit.
Although this may be less of an issue under a floating exchange rate system, too rapid a rate of economic growth may increase the demand for imports, such that the current account deficit has to be balanced by a surplus on the financial account.
What are the conflicts and trade-offs of economic growth and inflation?
A possible conflict may arise between economic growth and stability in prices, if an inappropriate strategy is adopted. It has been previously have argued that the key to achieving economic growth is supply-side policies that can lead to a rightward shift in the long-run aggregate supply (LRAS) curve. If the authorities try to encourage economic growth by using demand-side policies, the result may be upward pressure on the price level, which could lead to inflation if the policy continues in operation. You should by now be familiar with the way in which an increase in aggregate demand when the economy is at full employment has no effect on real GDP in the long run, but merely pushes up the equilibrium price level.
What are the conflicts and trade-offs of fiscal and monetary policy?
It was seen earlier that fiscal policy may have implications for the interest rate. If the government increases its expenditure, perhaps with the intention of improving infrastructure or subsidising education and training, one side effect could be to require higher borrowing and push up interest rates. This could in turn lead to an inflow of hot money, affecting the exchange rate and the competitiveness of domestic goods in international markets. This suggests that there may be circumstances in which fiscal and monetary policy come into conflict, given that interest rates are a key part of the transmission of monetary policy. Consequently, a way must be found of coordinating fiscal and monetary policy. This is naturally difficult to do, given the way that the Bank of England acts independently of the government in conducting monetary policy in order to meet the inflation target.
Over-enthusiastic use of discretionary fiscal policy can also interfere with the objective of maintaining a stable government budget position, and create problems for the economy in the future.
What are the conflicts and trade-offs of designing the policy mix?
Conflict may also arise because of trade-offs that exist between other policy objectives. Too rapid a rate of economic growth may put upwards pressure on prices, leading to inflation. Inflation may cause problems with international competitiveness, and therefore have an impact on the balance of payments. However, reducing demand in order to control inflation may lead to unemployment. Rapid economic growth may also increase inequality within a society, if only a minority of people enjoy the benefits - and growth may also cause damage to the environment.
The existence of these trade-offs makes it important to be able to design a policy mix that can resolve the conflicts, or at least reduce their consequences.
In the context of the aggregate demand/aggregate supply model, it is clear that demand- and supply-side policies are aimed at achieving rather different objectives.
The primary rationale for monetary and fiscal policies is to stabilise the macroeconomy. In this, fiscal policy has come to take on a subsidiary role, supporting monetary policy. This was not always the case, and there have been periods in which fiscal policy has been used much more actively to try to stimulate the economy. The fact that fiscal policy has not always been well implemented does not mean that such policies cannot be valuable tools - but it does warn against misuse.
In the UK, the use of monetary policy with the support of fiscal policy seemed to be working reasonably effectively until the onset of the financial crisis in late 2008. Furthermore, it seemed to be operating in such a way as to complement the supply-side policies. When a stable macroeconomic environment is created, microeconomic markets are able to operate effectively and investment is encouraged, thereby leading to a boost in aggregate supply. Supply-side policies aim to influence aggregate supply directly, either raising the supply of factor inputs or improving productivity and efficiency. However, the UK operates within the global economy, and the financial crisis brought with it a period of recession from which the economy was slow to recover.
The design and conduct of economic policy may therefore be seen as an elaborate balancing act. Differing policy objectives need to be prioritised, as in many cases there may be conflict between them. Choices have to be made about the balance to be achieved between fiscal, monetary and supply-side policies.
The consensus view in the early part of the twenty-first century was that fiscal policy should be used to achieve the desired balance between the public and private sectors. Monetary policy should be devoted to meeting the government’s inflation target in order to create a stable macroeconomic environment. This would then encourage growth and enable improvements in the standard of living. Problems arose when fiscal policy was forced into action in order to protect the financial system, resulting in an escalation of public debt.
In the long run, supply-side policies are perhaps the most important, as these contribute to raising efficiency and increasing the productive capacity of the economy. The keynote in policy design lies in enabling markets to operate as effectively as possible.
