Worked example 1
An economy has inflation at 6%, unemployment at 4% (below NAIRU of 5.5%), a current account deficit of 4% of GDP, and real GDP growth of 1%.
Which macroeconomic objectives are not being met? Discuss the policy trade-offs if the government prioritises reducing inflation. [12 marks]
Show solution outline
Objectives not met:
- Price stability — inflation 6% exceeds typical 2% target.
- BOP equilibrium — 4% current account deficit unsustainable long run.
- Growth — 1% is weak (though not necessarily failure if near full capacity).
Unemployment at 4% — below NAIRU → economy overheating, contributing to inflation.
Policy trade-offs if prioritising lower inflation:
- Contractionary monetary policy (raise rates) or fiscal tightening (↓G, ↑T):
- AD shifts left → inflation falls ✓
- Unemployment rises — from 4% toward NAIRU 5.5% ✗ (Phillips trade-off)
- Growth slows further ✗
- Currency may appreciate (high rates attract capital) → exports harder, deficit may persist ✗
Supply-side alternative:
- Raise productive capacity (LRAS right) — can lower inflation without sacrificing as much employment — but slow to implement.
Judgement: Given unemployment below NAIRU, some rise in unemployment is necessary to cool inflation — the trade-off is unavoidable short run. BOP may need separate expenditure-switching policy (11.1) if rate rises worsen competitiveness.