2.6.4 Conflicts and Tradeoffs between objectives and policies

These are notes for Edexcel Economics A students and teachers on tradeoffs between macroeconomic objectives.

Contents

Economic growth vs low, stable inflation

• Higher economic growth could be driven by higher aggregate demand (AD), for example following an increase in consumer confidence boosting consumption. AD shifting to the right raises the price level and is likely to raise the rate of inflation. This is demand-pull inflation.
• Higher economic growth may increase demand for labour to produce the extra output. This may raise wages in the labour market, increasing business costs. Firms may pass on higher wage costs to consumers by raising prices, leading to inflation.
  • This depends on the level of spare capacity in the economy. Using a Keynesian LRAS, a shift right in AD does not lead to an increase in the price level when there is high spare capacity. In other words, when there are large amounts of unused factors of production, raising demand for these factors of production will not bid up the price of these factors of production. So firms won’t need to increase prices of final goods.
  • Also this depends on the cause of the economic growth. Alternatively, higher economic growth could be driven by rising aggregate supply. In this case, higher economic growth leads to falling inflation rates. You can use an AS-AD diagram to show that as AS shifts right, real GDP rises while the price level falls.

Economic growth vs current account balance

• Economic growth may grow the current account deficit.
• Economic growth increases disposable incomes, so households spend more on imports.
• If economic growth is caused by a shift right in AD, the price level rises. So exports become more expensive and so export demand falls.
  • However again this depends on the cause of economic growth. If economic growth is caused by a shift right in (LR)AS, the price level will fall. This is likely to increase export competitiveness.
• Economic growth may lead the domestic currency to appreciate.
  • Economic growth may mean higher interest rates are required from the central bank to bring inflation down to its target level.
  • Higher interest rates mean hot money flows inwards into the country seeking a higher return. This increases demand for the domestic currency, leading to an appreciation.
• Appreciation makes imports cheaper, increasing import demand and the total spending on imports.
• Appreciation also makes exports more expensive. This reduces demand for exports and so the total revenue from exports may fall.
• So net exports decrease overall and the current account deficit widens.
  • Note the effects of a change in the value of the currency depend on the price elasticity of demand of exports and imports. See the exchange rate notes section on the Marshall Lerner condition.

Economic growth vs protecting the environment

• Economic growth increases demand for factors of production. This could include an increase in the use of natural resources such as fossil fuels and having more factories. This increases the level of pollution which damages the environment.
  • However economic growth may be driven by sectors that protect the the environment. This could include sectors like electric vehicles, renewable energy or energy efficiency measures such as double-glazed windows.
• As a result of economic growth, consumers experience higher real incomes. So consumers may consume more goods which may have an environmental impact during the process of consumption. This includes driving fuel-intensive cars or generating plastic waste from consumption.
  • Conversely many consumers are becoming more environmentally conscious. Consumers may consider how to reduce their carbon footprint, for instance by recycling and switching to greener alternatives.
  • Consumers may also boycott brands if they damage the environment heavily. So this may mitigate the impact of increasing consumption on the environment.
• Economic growth could cause the destruction of habitats to build factories or to gather raw materials such as wood through deforestation. This could lead to a loss of biodiversity.
  • However economic growth may lead to tighter regulations to safeguard the environment. This is because voters may become more aware of the greater environmental damage resulting from growth as the economy grows further. An example of this would be the European Union (EU)’s Deforestation Regulation will make it harder to import goods into the EU that have been derived from deforestation.

Economic growth vs reducing income inequality

• Economic growth may lead to higher inequality.
  • Technological progress can increase productivity, shifting LRAS right and boosting the rate of economic growth.
  • However, economic growth driven by technological progress can reduce demand for certain types of workers.
  • This could include manufacturing or manual labour jobs being replaced by robots.
  • More recently, some office jobs that require reading or writing documents could be offloaded to artificial intelligence such as ChatGPT. This can increase unemployment for some sectors.
  • Meanwhile those with skills needed to program or build robots, such as those with coding skills or engineers, could see higher labour demand and higher wages as a result of automation.
  • Economic growth could be driven by globalisation, when countries become increasingly interconnected.
  • This may result in a multinational company shifting its production overseas to a country with lower labour costs. Alternatively there may be greater international competition.
  • Both of these could reduce demand for domestic goods, reducing export demand and increasing unemployment. An example is the UK coal sector and UK deindustrialisation more broadly.
  • Meanwhile globalisation may lead to higher demand for financial services workers, due to the increase in cross-border financial flows.
• However economic growth may not necessarily lead to higher inequality.
  • The economic growth generated by technology can increase tax revenues. These tax revenues can go towards supporting those who lose their jobs with welfare payments.
  • In addition, those who lose their jobs, to automation or globalisation, may decide to retrain. They could learn new skills to work in a sector where there is increasing labour demand. This retraining could also be supported by the government with government funded training schemes.

Full employment vs low, stable inflation

• Falling unemployment means workers can bargain for greater wage rises. This is because workers have more bargaining power – firms will find it harder to replace workers when unemployment is low. So firms compete to hire workers, driving up wages.
• Higher wages increase firms’ production costs. These higher costs are passed on to consumers in the form of higher prices.
• For example in the UK economy in early 2023, unemployment was low at 3.7% while CPI inflation was high at 10.5%.
• The Phillips curve diagram below shows this. As unemployment falls from U to U1, inflation rises from I to I1 along the short-run Phillips curve.
• In addition, low unemployment, for given wages, means higher total incomes across the whole economy. This increases real disposable incomes, increasing consumer spending. This boosts aggregate demand, so AD shifts right, which leads to a higher price level. 
  • However this depends on the slope of the Phillips curve. Globalisation means a greater percentage of goods come from abroad.
  • So import prices are more important to the consumer basket. Import prices are largely determined by global supply and demand, less by domestic unemployment.
  • So a change in unemployment does not affect the prices of a significant proportion of the basket of goods. This means there is less of a tradeoff between unemployment and inflation.

Other possible tradeoffs exist. For example reducing income inequality may involve greater government spending on welfare and training schemes. This increases the budget deficit in the short term unless there are compensating tax rises.

How macroeconomic policies can lead to tradeoffs between macroeconomic objectives

• Monetary policy
  • Lower interest rates reduce the reward for saving and lower the cost of borrowing.
  • So consumption and investment rise. This shifts aggregate demand right, leading to higher economic growth and higher employment.
  • However lower interest rates also lead to higher inflation.
  • Lower interest rates can encourage speculation. Investors may look to borrow to invest in riskier assets, which could create asset price bubbles. This is where the price of an asset is above its fundamental value. This could create instability in the economy.
  • Quantitative easing (QE) involves the central bank using digital money to buy government bonds from other banks. These banks then have more funds to lend to businesses, increasing investment, AD and economic growth.
  • QE makes banks and financial institutions richer. Those with assets benefit from rising asset prices.
  • If house prices rise as a result of QE, those who do not own housing are worse off – it becomes more difficult for them to afford a house.
  • Therefore inequality may rise as a result of QE.
  • However the Bank of England argues that because QE increased employment and incomes, QE benefitted low and middle incomes groups too. Inequality may have been higher without QE.
• Fiscal policy
  • Higher government spending, such as on national defence, boosts aggregate demand. This increases the rate of economic growth and increases employment.
  • However increasing government spending also leads to higher inflation.
  • This could make exports less price competitive, reducing export demand and leading to a current account deficit.
  • Higher government spending could increase the budget deficit, if the government does not increase tax rates to raise revenue.
• Supply-side policies
  • Supply-side policies increase productive capacity of the economy, shifting LRAS right.
  • As a result, economic growth occurs and employment increases. The rate of inflation also falls, which makes exports more competitive.
  • However market-based supply-side policies such as privatisation, deregulation, removing workers’ rights or tax cuts may lead to higher income inequality.
    • For example, making it harder for workers to strike makes it more difficult for workers to collectively bargain for higher wages. This reduces firms’ costs which may increase firm profits, increasing payments to shareholders in the form of dividends.
  • Interventionist supply-side policies such as government spending on healthcare and education may increase the budget deficit.

Other relevant resources

To return to Edexcel Economics A A Level notes, click this button below:

For more A-Level Economics Edexcel A style resources, click the blue button below: