Written by: Edmund Quek

CHAPTER 21 CONFLICTS BETWEEN MACROECONOMIC GOALS

LECTURE OUTLINE 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 2 CONFLICTS Conflict between unemployment and inflation Conflict between unemployment and the balance of payments Conflict between unemployment and economic growth Conflict between inflation and economic growth Conflict between inflation and unemployment Conflict between inflation and the balance of payments Conflict between economic growth and inflation Conflict between economic growth and the balance of payments Conflict between economic growth and unemployment Conflict between the balance of payments and economic growth Conflict between the balance of payments and unemployment Conflict between the balance of payments and inflation 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

2011 Economics Cafe All rights reserved.

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Written by: Edmund Quek

1 1.1

CONFLICTS 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.

2011 Economics Cafe All rights reserved.

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Written by: Edmund Quek

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.

2011 Economics Cafe All rights reserved.

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Written by: Edmund Quek

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.

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.

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