• Policy decisions by?governments?often create a?trade-off?in the?macroeconomic objectives
• Achieving one objective may come at the cost of?worsening progress in another objective

An Explanation of the Common Trade-offs That Exist Between the Macroeconomic Objectives

• The?Short-run?Phillips Curve (SRPC)?observes that there may be a?trade-off?between unemployment and inflation
  • Rising inflation?is accompanied by?falling unemployment
  • Rising unemployment?is accompanied by?falling inflation
  • This?trade-off?makes it difficult for the government to achieve both low unemployment and low inflation

The Short-run Phillips Curve illustrates the relationship between changes to aggregate demand (AD), inflation & unemployment

Diagram Analysis

• The economy is initially in equilibrium?at AP1YFE
• At this point,?unemployment?is at 4% and?inflation?is at 3% and this is considered to be?full employment (YFE)
  • There is always some unemployment due to the?frictional?and?structural?unemployment that exists
• An?increase in AD?from AD1→AD2?causes a?positive output gap?(YFE-Y2)
  • With an increase in output the?demand for labour rises?& unemployment falls from 4%→3%
  • The remaining labour in the market is?scarcer?& workers are able to negotiate higher wages
    • This causes wage inflation in the economy
  • Wage inflation leads to an increase in?inflation?from 3%→4%
• A?decrease in AD?from AD1→AD3?causes a?negative output gap?(YFE-Y3)
  • With a decrease in output the?demand for labour falls?& unemployment rises from 4%→5%
  • Labour is more abundant & to get hired workers have to?accept lower wages
    • This causes?wage deflation?in the economy
  • Wage deflation leads to?a decrease in?inflation?from 3%→2%

• Similarly to the trade-offs that exist in achieving the different?macroeconomic objectives, there are?trade-offs & conflicts?that occur with the use of demand-side & supply-side policies

Example 1

• Raising interest rates?(contractionary monetary policy), eases demand-side inflationary pressure but raises the cost of borrowing for firms and slows down?supply-side investment
  • Tackling short term inflation, delays long term?supply-side growth

Example 2

• An increase in government spending?(expansionary fiscal policy)?can bring about improvements on the supply-side of the economy in the?long-run (LRAS)
  • Conversely, it may cause a shortage in?short-run aggregate supply (SRAS)?as government spending causes excess demand in the economy, leading to inflation

Example 3

• Increased?environmental policies?may lead to a fall in economic growth and lower LRAS
  • Fossil fuel industries have traditionally enabled increases in LRAS