Welcome to Macroeconomic Interrelatedness!
Hello future economist! You've already learned about the main macroeconomic problems: unemployment, inflation, slow growth, and balance of payments issues.
But these problems don't happen in isolation. They are all connected, often clashing with each other. This chapter is about understanding these vital connections, known as policy conflicts or trade-offs.
Why is this important? Because when a government tries to solve one problem (like unemployment), they might accidentally make another problem worse (like inflation)! This is the tough reality of managing an economy.
Quick Review: The Four Key Macroeconomic Objectives
- Economic Growth (High, sustainable growth)
- Low Unemployment (Achieving the Natural Rate of Unemployment, or NRU)
- Price Stability (Low and stable inflation)
- Balance of Payments Stability (Managing the Current Account)
1. Relationship between Internal and External Value of Money (10.2.1)
This relationship is crucial for understanding how domestic policies affect international standing, and vice versa.
a) Defining the Values
The Internal Value of Money refers to the purchasing power of money *within* the country. It is inversely related to the price level.
Example: If inflation is high, the internal value of your $10 note falls because it buys fewer goods.
The External Value of Money refers to the purchasing power of money *outside* the country, essentially the exchange rate.
Example: If the exchange rate falls from $1 = €0.90 to $1 = €0.80, the external value of the dollar has depreciated.
b) The Link: How Internal Inflation Weakens External Value
If a country experiences high domestic inflation (weak internal value), its goods become relatively more expensive compared to foreign goods.
- Domestic goods become less attractive to foreign buyers (exports fall).
- Domestic consumers buy more cheap imports (imports rise).
- This deterioration in the current account reduces the demand for the country's currency and increases the supply of the currency on foreign exchange markets.
- The currency depreciates, meaning the external value of money falls.
Key Takeaway
Inflation (weak internal value) generally leads to currency Depreciation (weak external value) under a floating exchange rate system.
2. Relationship between Balance of Payments and Inflation (10.2.2)
There is a strong two-way link between the current account balance and the rate of inflation.
a) How Inflation Worsens the Balance of Payments (Current Account Deficit)
As discussed above, if domestic inflation is higher than inflation in competitor countries, domestic products lose price competitiveness.
High Inflation → Exports are more expensive → Export Volume Falls.
High Inflation → Imports are relatively cheaper → Import Volume Rises.
Result: A larger Current Account Deficit (or a smaller surplus). This is a classic policy conflict.
b) How Balance of Payments Affects Inflation (Imported Inflation)
If the current account is in deficit, and the exchange rate depreciates to correct it, this can cause a specific type of inflation: cost-push inflation.
- Current Account Deficit leads to currency depreciation (weaker external value).
- The domestic currency buys fewer foreign goods.
- The price of imported raw materials, components, and consumer goods increases in domestic currency terms.
- Firms face higher costs, passing them on to consumers. This is imported inflation.
Did you know? This is why countries dependent on imported oil often see inflation spike immediately after their currency depreciates.
3. Relationship between Economic Growth and Inflation (10.2.3)
This relationship deals with the trade-off between achieving high growth (low unemployment) and maintaining price stability.
The AD/AS Model: Demand-Pull Inflation
Economic growth means increasing Real GDP. This is often driven by increases in Aggregate Demand (AD) (e.g., through higher consumer spending or government investment).
- If the economy is operating well below full capacity (there are many unemployed resources), an increase in AD will lead to high growth with little increase in the price level.
- However, if the economy approaches Full Capacity (maximum potential output), resources become scarce.
- Further increases in AD (expansionary policies aimed at growth) will cause Demand-Pull Inflation because firms cannot increase output quickly enough to meet the new demand.
Analogy: Think of a stadium filling up. When it's half full, bringing in more fans (AD) just increases attendance (GDP). But when the stadium is already full, trying to squeeze in more fans just causes overcrowding and fights (inflation) without increasing actual attendance (max GDP).
Key Takeaway
There is often a trade-off: rapid growth usually comes with the cost of higher inflation, especially if the growth is demand-led and the economy is near capacity.
Struggling with diagrams? Remember the steepness of the SRAS curve. When SRAS is steep (near full capacity), an AD shift results mostly in price increase (inflation) and little output increase (growth).
4. Relationship between Economic Growth and the Balance of Payments (10.2.4)
This is often called the Growth-Balance of Payments Trade-off.
The Import Effect of Growth
When an economy achieves strong growth, national income (Y) rises. This leads to higher consumer spending (C). Because people spend money on both domestic and imported goods, imports (M) tend to rise significantly.
- Growth → Higher National Income and Wealth.
- Consumers increase consumption, including spending on foreign cars, electronics, and holidays.
- The Marginal Propensity to Import (MPM) determines how much imports increase for every extra unit of income. Since MPM is usually positive, imports rise faster than exports.
- Result: The Current Account moves towards a deficit.
This means policies promoting high economic growth may conflict with the objective of achieving a stable balance of payments.
Can Growth Improve the BoP?
Yes, sometimes! If the growth is driven by Supply-Side Policies (which increase efficiency and productive capacity) rather than just AD:
- If growth leads to greater productivity, domestic goods become cheaper and more competitive globally.
- This increases exports (X) and reduces imports (M).
- Result: The Current Account *improves*.
Quick Review Box: Growth Trade-offs
AD-driven Growth → Conflict (Causes Inflation and BoP Deficit)
AS-driven Growth → Harmony (Lowers Inflation and Improves BoP)
5. Relationship between Inflation and Unemployment (The Phillips Curve) (10.2.5)
This is perhaps the most famous and historically significant macroeconomic trade-off.
a) The Traditional Phillips Curve (PC)
In 1958, economist A.W. Phillips observed an inverse relationship: when unemployment was high, inflation was low, and vice versa.
- The Traditional PC is a downward-sloping curve.
- The Logic: Low unemployment means labour markets are tight. Firms must compete for scarce workers by offering higher wages. Higher wages increase costs, leading to cost-push inflation.
Policy implication: Governments believed they could "choose" a point on the curve—e.g., accept 5% inflation to achieve 3% unemployment.
b) The Breakdown: Stagflation
In the 1970s, many countries experienced Stagflation—high inflation *and* high unemployment simultaneously! This contradicted the traditional Phillips Curve, showing the trade-off was not permanent. Economists needed a better model.
c) The Expectations-Augmented Phillips Curve (EAPC)
The EAPC, primarily developed by economists Friedman and Phelps, introduced the idea of inflation expectations. The trade-off only exists in the short run.
i) Short-Run Phillips Curve (SRPC)
The SRPC still shows a trade-off. However, its position depends entirely on what workers and firms expect the inflation rate to be.
Step-by-Step Scenario (Moving from A to B on an SRPC):
- The economy starts at point A (e.g., 5% unemployment, 2% expected inflation).
- Government uses expansionary policy (e.g., tax cuts) to reduce unemployment.
- Demand rises rapidly, causing actual inflation to rise to 4%.
- Since workers haven't yet realised the true inflation (they still expect 2%), their *real* wage has fallen. Firms hire more workers at the lower real wage, and unemployment falls (e.g., to 3%). The economy moves to point B.
- The short-run trade-off has been exploited.
ii) Long-Run Phillips Curve (LRPC) and the NRU
The short-run gain in employment (moving from 5% to 3%) is temporary.
- Workers eventually realise that inflation is 4%, not 2%. They demand higher wages to restore their purchasing power.
- Firms' costs rise, reducing profit margins. They lay off workers, and unemployment returns to its original level (5%).
- The economy moves to point C, which is directly above A (4% inflation, 5% unemployment). The entire SRPC shifts upwards.
The Long-Run Phillips Curve (LRPC) connects points A and C. It is vertical at the Natural Rate of Unemployment (NRU) (sometimes called the NAIRU - Non-Accelerating Inflation Rate of Unemployment).
- The NRU is the level of unemployment that exists when the labour market is in equilibrium, accounting for structural and frictional unemployment.
- The LRPC is vertical because in the long run, expansionary policy only increases inflation expectations, not employment.
- Policy can only permanently reduce unemployment if it shifts the NRU to the left (e.g., through Supply-Side Policies like better training).
Final Thought on Policy Conflicts
These interconnected problems mean governments rarely achieve all four macroeconomic goals simultaneously. They must constantly make difficult policy choices and accept painful trade-offs.
For example, to cure high inflation, contractionary policies might be used, but the unavoidable cost is likely slower growth and higher unemployment in the short term.