Written by: Edmund Quek

© 2011 Economics Cafe All rights reserved. Page 1

CHAPTER 21

CONFLICTS BETWEEN MACROECONOMIC GOALS

LECTURE OUTLINE

1 CONFLICTS

1.1 Conflict between unemployment and inflation

1.2 Conflict between unemployment and the balance of payments

1.3 Conflict between unemployment and economic growth

1.4 Conflict between inflation and economic growth

1.5 Conflict between inflation and unemployment

1.6 Conflict between inflation and the balance of payments

1.7 Conflict between economic growth and inflation

1.8 Conflict between economic growth and the balance of payments

1.9 Conflict between economic growth and unemployment

1.10 Conflict between the balance of payments and economic growth

1.11 Conflict between the balance of payments and unemployment

1.12 Conflict between the balance of payments and inflation

2 NO CONFLICTS

References

John Sloman, Economics

William A. McEachern, Economics

Richard G. Lipsey and K. Alec Chrystal, Positive Economics

G. F. Stanlake and Susan Grant, Introductory Economics

Michael Parkin, Economics

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics

Written by: Edmund Quek

© 2011 Economics Cafe All rights reserved. Page 2

1 CONFLICTS

1.1 Conflict between unemployment and inflation

If the government increases aggregate demand to reduce unemployment, inflation will rise

and this short-run trade-off can be shown by the short-run Phillips curve.

In the above diagram, when the unemployment rate () falls from 0 to 1, the inflation rate

() rises from 0 to 1.

1.2 Conflict between unemployment and the balance of payments

If the government increases aggregate demand to reduce unemployment, the increase in

national income and the general price level will lead to a decrease in net exports. If the

economy initially has a balance of payments equilibrium, the balance of payments will

move into a deficit. Under the fixed exchange rate system, the balance of payments deficit

will be persistent.

1.3 Conflict between unemployment and economic growth

From section 2.2, under the flexible exchange rate system, although the resultant

depreciation of domestic currency will correct the balance of payments deficit, it may

induce people to sell it in anticipation of further falls in the exchange rate which may lead

to currency instability. If this happens, inward foreign direct investments and hence

economic growth will fall.

Written by: Edmund Quek

© 2011 Economics Cafe All rights reserved. Page 3

1.4 Conflict between inflation and economic growth

If the government decreases aggregate demand to reduce inflation, economic growth will

fall.

1.5 Conflict between inflation and unemployment

If the government decreases aggregate demand to reduce inflation, unemployment will rise

and this trade-off can be shown by the short-run Phillips curve.

In the above diagram, when the inflation rate () falls from 0 to 1, the unemployment rate

() rises from 0 to 1.

1.6 Conflict between inflation and the balance of payments

If the government decreases aggregate demand to reduce inflation, the decrease in national

income and the general price level will lead to an increase in net exports. If the economy

initially has a balance of payments equilibrium, the balance of payments will move into a

surplus. Under the fixed exchange rate system, the balance of payments surplus will be

persistent.

1.7 Conflict between economic growth and inflation

If the government increases aggregate demand to increase economic growth, inflation will

rise.

Written by: Edmund Quek

© 2011 Economics Cafe All rights reserved. Page 4

1.8 Conflict between economic growth and the balance of payments

If the government increases aggregate demand to increase economic growth, import

growth will rise. If the economy initially has a balance of payments equilibrium, the

balance of payments will move into a deficit. Under the fixed exchange rate system, the

balance of payments deficit will be persistent.

1.9 Conflict between economic growth and unemployment

If the government increases productivity growth to increase economic growth by

increasing expenditure on research and development, skills and knowledge will become

obsolete at a faster pace which will lead to a rise in structural unemployment.

1.10 Conflict between the balance of payments and economic growth

If the government decreases aggregate demand to correct a persistent balance of payments

deficit, economic growth will fall.

1.11 Conflict between the balance of payments and unemployment

If the government decreases aggregate demand to correct a persistent balance of payments

deficit, unemployment will rise.

1.12 Conflict between the balance of payments and inflation

If the government increases aggregate demand to correct a persistent balance of payments

surplus, inflation will rise.

2 NO CONFLICTS

Although there are potential conflicts among the four macroeconomic goals, achieving

success in one does not always lead to failure in another. For instance, if the government

increases aggregate demand to increase economic growth, demand-deficient

unemployment will fall. Further, if there is initially deflation in the economy, the increase

in aggregate demand may lead to low inflation which is desirable for the economy. In

addition, if the economy initially has a persistent balance of payments surplus, the higher

import growth due to the higher economic growth may correct the surplus.