Judging the trade-offs: how sharp is a conflict?

Overview

Time lags make policy conflicts harder to manage and policy conflicts be reduced but never entirely removed.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is the difference between saying two objectives conflict and saying they involve a trade-off?

   Model answer

   A conflict means the objectives move in opposite directions when policy acts, so gaining on one costs something on the other. A trade-off states the rate of that exchange: how much inflation must be accepted per percentage point of unemployment removed. Naming the conflict identifies the problem, while quantifying the trade-off is what allows a government to decide whether the exchange is worth making.

2. 2

   Why does the size of the output gap determine how severe the growth and inflation conflict is?

   Model answer

   The output gap measures how far actual output is from the economy's productive potential, and it determines the slope of short-run aggregate supply in the relevant region. With a large negative gap the curve is flat, so extra demand raises output with little effect on prices and the conflict is mild. As the gap closes the curve steepens and the same demand increase delivers progressively less output and more inflation, so the conflict becomes severe.

3. 3

   How do time lags make policy conflicts harder to manage?

   Model answer

   There is a recognition lag while the data reveal what the economy is doing, a decision lag before policy is changed, and an implementation lag before the change reaches spending and prices, which for interest rates can run to a year or more. By the time the effect arrives the economy may be in a different position, so a measure designed to close a negative output gap can land in a boom and add to inflation. Lags therefore mean policy can worsen the very conflict it was meant to resolve, which is an argument for acting on forecasts rather than on current readings.

4. 4

   Why can two objectives be complementary at one moment and in conflict at another?

   Model answer

   The relationship depends on where the economy is relative to capacity and on what is causing the change. With substantial spare capacity, extra demand raises output and employment with little inflation, so growth and price stability sit comfortably together. Once capacity is reached the same policy raises prices instead of output, so the two objectives collide. The relationship is therefore conditional on the state of the economy rather than fixed.

5. 5

   Why does the source of an inflation shock change what the right policy response is?

   Model answer

   Demand-pull inflation arises because aggregate demand exceeds what the economy can supply, so reducing demand removes the cause and restores the price level without leaving a permanent output loss. Cost-push inflation arises from a leftward shift of short-run aggregate supply, so output is already falling; reducing demand attacks a cause that is not there and deepens the output loss. Diagnosing which shift has occurred is therefore the first step, and the diagnostic evidence is whether output and prices are moving in the same direction, as with demand-pull, or in opposite directions, as with cost-push.

6. 6

   Assess whether a single policy instrument can be used to hit two macroeconomic targets at once.

   Model answer

   In general it cannot. An interest rate change moves the price level and real output together in the same direction, so it can be set to achieve a desired inflation outcome or a desired output outcome but not both independently unless the two happen to require the same setting. Achieving two targets independently requires two instruments acting through different channels, for instance monetary policy for inflation and supply-side or fiscal measures for capacity and employment. There is a partial exception when the shock hits both targets in the same direction, as with a demand shock, since one instrument then corrects both; but a supply shock moves them in opposite directions and one instrument must choose.

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