Where the objectives collide: the main policy conflicts

Overview

Conflict between economic growth and environmental objectives, strong growth and a strengthening currency together squeeze manufacturing employment and argument that supply-side policy escapes the conflicts between macroeconomic objectives.

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

   By what mechanism can pursuing faster growth worsen inflation?

   Model answer

   Policy that raises aggregate demand shifts the AD curve to the right on a diagram with the general price level on the vertical axis and real national output on the horizontal axis. If the economy is operating near capacity the short-run aggregate supply curve is steep, because firms must bid for scarce labour and materials to produce more. The new equilibrium therefore delivers a large rise in the price level for a small rise in real output, so the growth objective is met only partially while the inflation objective deteriorates.

2. 2

   Why does reducing unemployment through higher demand tend to put upward pressure on inflation?

   Model answer

   As unemployment falls the pool of available workers shrinks, so firms wanting to expand must offer higher wages to attract staff from other employers or to persuade the inactive to join. Higher wages raise firms' costs, and firms with any pricing power pass part of the increase into prices. At the same time the newly employed spend their wages, adding to aggregate demand, so pressure comes from both the cost and the demand side. In the short run, then, lower unemployment and higher inflation tend to move together.

3. 3

   Why does faster economic growth tend to worsen the current account of the balance of payments?

   Model answer

   Rising national income raises consumer spending, and a proportion of every extra pound spent goes on imported goods and on domestic goods with imported components, so import spending rises with income. Exports, by contrast, depend on income in other countries rather than at home, so they do not rise for the same reason. Imports therefore grow faster than exports and the trade balance deteriorates. The effect is stronger the higher the country's share of extra income spent on imports and the more its growth is driven by consumption rather than exports.

4. 4

   Analyse the conflict between economic growth and environmental objectives.

   Model answer

   Higher output requires more energy and more raw materials, and with current technology this means higher emissions and faster depletion of natural resources, so the environmental objective moves in the wrong direction as output rises. The damage is a negative externality of production and consumption, so it does not appear in market prices and firms have no private reason to limit it. Policies that internalise the cost, such as carbon taxes or emissions permits, raise firms' costs of production and shift short-run aggregate supply to the left, reducing output and raising the price level, so the conflict simply reappears as a growth cost. The conflict is softened where growth comes from cleaner technology or from a shift towards services, and where higher incomes fund the investment that abatement requires, but it is real wherever output and emissions remain tightly linked.

5. 5

   Why can a period of rapid growth widen the gap between rich and poor?

   Model answer

   The gains from growth accrue in the first instance to the owners of whatever factor is scarce and in demand, which is typically capital and skilled labour, so profits and high salaries rise faster than the wages of the low-skilled. Technological change that raises productivity often substitutes for routine work while complementing skilled work, widening the wage gap further. Asset prices such as housing and shares also rise during expansions, benefiting those who already own assets and excluding those who do not.

6. 6

   How does policy to bring inflation down raise unemployment in the short run?

   Model answer

   Reducing inflation caused by excess demand requires reducing that demand, typically by raising interest rates or tightening fiscal policy, which shifts aggregate demand to the left on a diagram with the price level on the vertical axis and real output on the horizontal axis. At the new equilibrium both the price level and real output are lower. Because firms need fewer workers to produce the lower output, employment falls and cyclical unemployment rises. The unemployment is the mechanism by which inflation falls, since a weaker labour market reduces the wage increases firms grant.

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