AS Macro Revision: Macro Objectives and Conflicts

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Information about AS Macro Revision: Macro Objectives and Conflicts

Published on February 21, 2014

Author: tutor2u


AS Macro Revision Possible Conflicts between Macroeconomic Objectives Spring 2014

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Possible Conflicts between Macro Policy Objectives A crucial part of AS macro analysis and evaluation is to consider the causes of possible conflicts between key objectives • It is rare for a country to achieve all of its main macroeconomic aims at the same time • Sustainable and balanced economic growth • Falling unemployment / rising employment rate • Price stability i.e. Low but positive rate of inflation • Equilibrium on a country’s external balance of payments • Frequently conflicts can appear between the different aims • As a result, choices might have to be made about which objectives are to be given greatest priority • The extent of these trade-offs between objectives will vary from one country to another since the needs of different nations will differ according to their stage of economic development

Examples of Possible Conflicts Unemployment and inflation (price stability) Economic growth and inflation Conflicting Aims? Economic growth and the balance of payments Economic Growth and Inequality Views about which macroeconomic aim ought to be given most importance involve making value judgements

The Phillips Curve – Unemployment and Inflation The Phillips Curve shows a trade-off between inflation and unemployment. A demand-side policy to reduce unemployment could conflict with price stability As the rate of 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 their prices to increase their profit margins Inflation Trade-off is worsening as the economy comes up against capacity constraints A favourable trade-off because the economy SRAS is elastic when unemployment is high P3 P2 P1 U3 U2 Unemployment

Unemployment and Inflation Rates in the UK Economy Between 2000 and 2007 the UK enjoyed low inflation and low unemployment. In recent years inflation has been volatile and higher than target. Unemployment peaked at 8.5% in 2011 and is now falling The Misery Index is calculated by adding together the unemployment rate and the rate of inflation. A rising Misery Index signals a worsening policy conflict!

Possible Conflicts between Growth and Inflation An overheating (fast-growing) economy may suffer accelerating inflation which then has negative effects on trade performance, business profits and jobs The risk of accelerating inflation is greatest when short run aggregate supply is inelastic i.e. When the economy has low spare capacity If an economy suffers high inflation and a slowdown in economic growth – this is called stagflation GPL AD1 AD2 AS GPL2 GPL1 The conflict between growth and inflation can be resolved by having effective supply-side economic policies Y1 Y2 Real GDP

A Worsening Trade-Off between Growth and Inflation General Price Level GPL5 AS An outward shift in AD from AD3 to AD4 causes a sharp rise in the general price level because AS in elastic (output is close to capacity levels) AD5 GPL4 AD4 AD3 AD1 Real GDP AD2 Y3 Y4

Growth and Inflation in the UK Economy The UK inflation target is 2% for CPI. Inflation has been at or above 2% for most of the last eight years. Growth has been volatile with a deep recession in 2009 and a slow recovery 20102013 Real economic growth of 2-3% and inflation at similar rates can be viewed as a relatively successful macroeconomic achievement

Economic Growth and the Balance of Payments A period of fast growth may come into conflict with the balance of payments. Much depends on the income elasticity of demand for traded goods and services When real incomes are rising at a rapid rate, consumers will tend to buy more imports – leading to a worsening of the trade balance Fast growing countries may suffer from high inflation which worsens the competitiveness of domestic industries including exporters Businesses will need to import extra raw materials, components and capital equipment to help expand production.

Growth and the Current Account (BoP) for the UK The UK economy has run a current account deficit every year for many years – usually more than 2% of GDP. Slow export growth to the EU has been a factor behind the continued BoP deficits. The possible conflict between growth and the balance of payments depends to a degree on the stage of development that a country has reached

Policies to Improve Growth and the Trade Balance Supply-side policies • Reforms to improve labour productivity • Incentives to boost research & development & innovation • Measures to increase investment in export sectors Exchange rate depreciation • A depreciation of the currency (in theory) makes exports more price competitive and imports are more expensive • But the effects are dependent on price elasticity of demand Sound Macro Economic Policies • Monetary policy to help keep inflation low relative to the inflation of major trading competitors • Infrastructural investment to increase export competitiveness

Possible Conflicts between Macro Policies The use of one macro policy can sometimes outweigh the impact of another – leading to policy conflict or reduced effectiveness • Policies designed to meet environmental goals might damage the competitiveness of domestic businesses in international markets. E.g. A carbon tax or a minimum price on C02 emission permit • Measures to reduce inequality such as higher top rate income taxes or increased VAT on luxury consumer products may have consequences for inflation, trade and jobs • Expansionary fiscal policies involving higher government borrowing that have the effect – in the medium term – of driving inflation and interest rates higher (this is known as crowding out) • The effects of changes in interest rates on the distribution of income e.g. the effects on millions of savers of the period of exceptionally low interest rates in the UK over recent years

Economic Growth and Inequality In many countries, a period of fast economic growth can lead to a widening of inequality of income and wealth “Half of one’s income depends on the average income of the country in which that person was born.” “8% of humanity takes home 50% of global income; the top 1% alone takes home 15%.” “The richest 300 people on earth have more wealth than the poorest 3bn - almost half the world's population.” “Shared prosperity is defined as “fostering income growth of the bottom 40% of the population in every country” (World Bank, 2013). Branko Milanovic, World Bank economist and an expert on trends in global inequality “Global inequalities are a lot higher than those within any country of the world, including Brazil or South Africa, the Gini-coefficient of the world is estimated at 0.70, while the one of a country like Brazil is below 0.60.”

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