Links between macroeconomic problems and their inter-relatedness

The Phillips curve shows the relationship between inflation and unemployment, and the short-run and long-run versions give different conclusions.

The short-run Phillips curve (SRPC) slopes downward, showing an inverse trade-off: lower unemployment is associated with higher inflation, and vice versa. The reasoning is that when a government boosts aggregate demand, unemployment falls as firms hire more workers, but the tightening labour market pushes up wages and prices, raising inflation (a movement up the SRPC). Conversely, reducing AD raises unemployment but lowers inflation. So in the short run a government appears able to 'choose' a combination of inflation and unemployment along the curve.

The expectations-augmented (long-run) Phillips curve (LRPC) is vertical at the natural rate of unemployment (NRU), showing no permanent trade-off. Starting at the NRU, suppose the government boosts AD to push unemployment below the NRU — moving up the SRPC, raising inflation. Workers initially accept the lower real wage, but once they expect the higher inflation, they demand higher wages to restore their real wage. Higher wages raise firms' costs, so employment falls and unemployment returns to the NRU — but now at higher inflation (the SRPC has shifted up). Repeating this just produces ever-higher inflation at the same NRU, so the long-run curve is vertical.

The key implication is that demand-side policy can only change unemployment temporarily — it cannot hold unemployment below the natural rate without causing accelerating inflation. To reduce unemployment permanently, the natural rate itself must be lowered through supply-side policies (retraining, improved labour mobility, better incentives), which shift the LRPC to the left. So while there is a short-run trade-off between inflation and unemployment, there is no long-run trade-off — the long-run cure for unemployment is supply-side, not demand-side.

Macroeconomic objectives are interconnected, so pursuing one often affects the others. Whether all four — low inflation, low unemployment, growth and a stable balance of payments — can be achieved together is a central A-Level question.

The case that they conflict (cannot all be achieved). Several links create trade-offs. The Phillips curve shows that boosting AD to cut unemployment raises inflation (a short-run trade-off), and pushing unemployment below the natural rate causes accelerating inflation (the vertical long-run Phillips curve). Faster growth (demand-led) raises incomes and imports, worsening the current account — a conflict between growth and BoP stability. Higher relative inflation worsens competitiveness and the current account. Using contractionary policy to control inflation or the deficit raises unemployment and slows growth. Because of these links, demand-side policy that improves one objective tends to worsen another, suggesting all four cannot be achieved simultaneously.

The case that they can (sometimes) be achieved together. The conflicts are not absolute. With substantial spare capacity (a deep recession), expansionary policy can raise growth and cut unemployment with little inflation, improving several objectives at once. More importantly, supply-side policies can ease the conflicts: by raising productivity and capacity (shifting LRAS and the LRPC right/left), they allow growth without inflation, lower the natural rate (cutting unemployment without inflation), and improve competitiveness (helping the current account). So supply-side reform can move the economy toward several objectives together, escaping the demand-side trade-offs.

Judgement. Whether all four objectives can be achieved together depends on the economy's position and the policy used. Using demand-side policy alone, especially near full capacity, they generally cannot all be met — the inflation-unemployment and growth-BoP conflicts bite, so the view has real force. However, with spare capacity or, crucially, through supply-side policy that raises capacity and competitiveness, an economy can make progress on all four simultaneously, because supply-side improvements are not subject to the same trade-offs. The most defensible conclusion is that the objectives conflict in the short run under demand management, so they cannot all be maximised at once, but supply-side policy can reduce these conflicts over the long run, allowing an economy to move toward all four together. So the view is largely true for demand-side policy but too pessimistic if supply-side measures are used.

The country's experience illustrates the inter-relatedness of macroeconomic problems — strong growth is linked to both rising inflation and a worsening current account.

Growth and inflation. The strong growth appears to be demand-led and the economy is likely near full capacity (a positive output gap). As aggregate demand rises against limited spare capacity, firms cannot easily produce more, so the extra demand pulls up prices — demand-pull inflation. So fast demand-driven growth and rising inflation are linked.

Growth and the current account. The growth raises households' incomes, which increases their spending on imports (especially income-elastic imports). With exports growing more slowly, rising imports worsen the current-account deficit — a conflict between growth and balance-of-payments stability.

Inflation reinforcing the deficit. The rising inflation also makes the country's exports relatively dearer and imports relatively cheaper, reducing competitiveness and further worsening the current account — so inflation and the deficit reinforce each other.

This shows why a government cannot treat these objectives in isolation: strong demand-led growth has simultaneously caused inflation and a deficit. To grow without these side effects, the country would need supply-side policy to raise capacity (easing inflation) and competitiveness (improving the current account).

Reducing a current-account deficit can conflict with other objectives, because the policies used affect inflation, unemployment and growth.

Why demand-side measures harm other objectives. Expenditure-reducing policy (contractionary fiscal or monetary policy) cuts AD to reduce imports and the deficit — but lower AD raises unemployment and slows growth, conflicting with those objectives. A depreciation (expenditure-switching) makes exports cheaper and imports dearer, improving the current account, but the dearer imports cause cost-push inflation, conflicting with price stability — and it only works if demand is elastic. Protectionism risks retaliation and raises prices. So the standard demand-side and exchange-rate routes to a smaller deficit tend to harm inflation, unemployment or growth.

Why supply-side measures may avoid the conflict. Supply-side policy that raises productivity and competitiveness (investment in training, infrastructure, technology) can improve the current account by making exports more competitive and reducing import dependence — without cutting AD. Because it also raises capacity and growth and can lower the natural rate of unemployment, it can improve the current account while supporting the other objectives, not harming them. The catch is that supply-side policy is slow and costly.

Judgement. Using demand-side or exchange-rate policy, a government generally cannot reduce a current-account deficit without harming other objectives — there are real trade-offs (lower growth/higher unemployment, or higher inflation). However, using supply-side policy to improve competitiveness, it can reduce the deficit while supporting growth and employment and without causing inflation — escaping the conflict, albeit slowly. The most defensible conclusion is that the conflict is real for short-run demand-side measures but avoidable through long-run supply-side reform, so the best way to reduce a deficit without harming other objectives is to improve competitiveness via supply-side policy, accepting that it takes time.