Links between macroeconomic problems and their interrelatedness — practice questions

Interrelationships:

1. Cost-push shock → SRAS shifts left → higher average price level (6% inflation) AND lower real output.
2. Lower output → firms demand fewer workers → unemployment rises 5% → 7% (cyclical element on top of any structural).
3. Stagflation: inflation and unemployment move in same (bad) direction — Phillips trade-off breaks down.
4. Growth slows — third objective harmed.
5. If oil is imported, import bill rises → current account worsens → fourth objective harmed.

Policy dilemma:

• Expansionary policy (↓ rates, ↑ G): boosts AD → helps unemployment and growth BUT adds to demand-pull inflation on top of cost-push — inflation may accelerate further.
• Contractionary policy (↑ rates): may anchor inflation expectations BUT deepens recession and unemployment — does not fix supply-side cause.

Best response:

• Supply-side: energy efficiency, alternative fuels — shifts SRAS back right (long run).
• Targeted support for worst-hit sectors — limited fiscal cost.
• Monetary policy: may need to tolerate temporary inflation if expectations remain anchored — harsh tightening risks deep recession.

Judgement: No easy win — policymakers face conflicting objectives because the root cause is supply-side, not demand deficiency.

1. Impact on Inflation (Primary Objective):

• The increase in interest rates from 4% to 6% makes borrowing more expensive for consumers and firms, and saving more attractive.
• This leads to a reduction in consumption (C) and investment (I), two major components of Aggregate Demand (AD).
• The AD curve shifts to the left, reducing pressure on the general price level. Inflation is expected to fall from 8% towards the 2% target, though this effect typically has a time lag of 12-24 months.

2. Impact on Growth and Unemployment (The Trade-off):

• The leftward shift of the AD curve means a lower level of real output and income.
• Economic growth will slow down, potentially falling from 2.5% to below 1% or even turning negative (a recession).
• With lower output, firms' demand for labour decreases, leading to a rise in cyclical (demand-deficient) unemployment. Unemployment might rise from 4% to 5.5% as the economy cools.
• This demonstrates the classic short-run Phillips Curve trade-off: the policy to reduce inflation worsens unemployment and growth.

3. Impact on the Balance of Payments (Spillover Effects):

• Financial Account & Exchange Rate: The higher interest rate (6%) relative to other countries attracts foreign financial investment ('hot money'). This causes a significant inflow of capital, leading to a surplus on the financial account. The increased demand for Econland's currency causes it to appreciate, for example, by 5% against major trading partners.
• Current Account: There are conflicting effects:
  • (a) Income Effect: Slower economic growth reduces domestic income, leading to lower spending on imports. This effect improves the current account balance.
  • (b) Exchange Rate Effect: The stronger currency makes Econland's exports more expensive for foreigners and imports cheaper for domestic residents. This effect worsens the current account balance.
• The net effect on the current account is uncertain, but the exchange rate effect often dominates in the medium term, leading to a wider deficit.

Evaluation/Judgement: The central bank's action directly addresses the inflation problem but creates conflicts with other macroeconomic objectives. It knowingly sacrifices short-term growth and employment to achieve price stability. The impact on the external sector is complex, with the appreciation of the currency posing a risk to the country's international competitiveness. The success of the policy depends on whether it can lower inflation without causing an unacceptably deep recession.