It is rare for any government to be able to meet all its objectives at the same time. The complexity of the economy and the limitations of economic policies make this a really tough task! In this chapter we consider possible trade-offs between the key policy objectives.

There are potential trade-offs between objectives imply that choices between different goals may have to be made in the short and medium run.

1. Should the highest priority be given to keeping inflation firmly under control?
2. Or can the British economy now operate at a higher level of GDP growth and lower unemployment without worrying too much about the inflationary consequences?
3. Should the government be concerned about a large and rising trade deficit with other countries?  Or can the trade deficit be ignored because it is the result of a high level of short term growth and strong consumer spending?

Unemployment and Inflation – the Phillips Curve

Is there a trade-off between unemployment and inflation?

Arguments for a trade-off:

When unemployment falls to low levels, there is a risk that wage and price inflation will pick up. The demand for labour is increasing and labour shortages in many industries and occupations may arise. This puts upward pressure on pay as employers offer higher pay both to recruit and retain their key workers. 

Falling unemployment leads to an increase in AD which can lead to demand pull inflation if SRAS is inelastic and the output gap has become positive.  As the economy heads towards full-employment, there is a danger than inflation will accelerate and that economic policy will have to be tightened (for example a rise in taxation or an increase in interest rates). The diagrams below illustrate an outward shift of the demand for labour during an economic boom and an increase in AD from AD1 to AD2 when SRAS is inelastic.

 

Counter-arguments
Unemployment has many causes and there is no automatic rule that falling unemployment must lead to rising inflation. It is widely acknowledged that the relationship between unemployment and inflation in the UK (and some other countries) has altered over the last fifteen years. As a consequence, the British economy has enjoyed a very long period of falling unemployment without any significant acceleration in inflation. This is shown in the data chart on the next page.

 

Why has the “trade-off” between unemployment and inflation changed?

Some economists point to the effect of supply side improvements in the British economy such as higher capital  investment; increases in productivity, lower labour costs and the benefits of rapid innovation.  All of these factors have helped to increase the supply-side potential of the economy which has contributed to a period of non-inflationary growth.

But it would be wrong to automatically assume that inflation is now dead! There are plenty of possible causes of a return to higher inflation. For example, the UK is not immune to fluctuations in global commodity prices, or the effects of a sharp fall in the exchange rate. And too much domestic demand for goods and services, perhaps driven by the continued boom in house prices and consumer borrowing, might also bring about a return of demand-pull inflationary pressure.

Is there a trade-off between economic growth and inflation?

Arguments for the trade-off

Sustained growth caused by rising aggregate demand can lead to acceleration in inflation as the economy uses up scarce resources and short run aggregate supply becomes inelastic. When SRAS is elastic, an outward shift of aggregate demand can easily be met by a rise in real GDP (there is plenty of spare capacity and supply responds elastically to the higher level of AD). But when SRAS becomes inelastic, the trade-off between growth and inflation worsens – an increase in AD tends to lead to higher prices rather than increased output and employment.

Counter-arguments

The trade off between growth and inflation can be avoided if an economy is able to increase potential output by improving their supply-side performance. For example, LRAS can be increased by achieving sustained improvements in productivity, advances in technology and the benefits that come from product and process innovations. Potential output is also increased by expanding the stock of capital goods (via higher investment) and through an increase in the available labour supply.

An outward shift in LRAS means that the economy can meet a higher level of aggregate demand without putting upward pressure on the general price level. This is shown in the diagram below. LRAS has moved to the right (an increase in potential GDP). Aggregate demand has also shifted out (perhaps due to lower interest rates or higher real incomes for consumers). Equilibrium national output increases from Y1 to Y2 – the level of output Y2 would not have been feasible without a shift in LRAS.

 

Clearly those countries that grow very quickly are at risk of rising inflation. The key is to keep control of aggregate demand (using monetary and fiscal policy) whilst at the same time seeking to increase aggregate supply through improvements in efficiency and the stock of available resources.

If we look at the data for economic growth and inflation in the UK over the last fifteen years, we see that there has indeed been an improvement in the trade-off between these two objectives. In the late 1980s, an economic boom got out of control and excess demand led to a sudden and sharp rise in cost and price inflation. The rate of inflation peaked at over 10% in 1990 and interest rates were increased up to a maximum of 15% in order to bring aggregate demand under control. The result of this was a deep recession lasting for nearly two years – the effect of which was to reduce inflation but which also caused a huge rise in unemployment.

Since the early 1990s the British economy has enjoyed a period of relative macroeconomic stability, with a sustained phase of economic growth allied to continued low inflation. There have been some years of very strong growth (for example in 1997 when real GDP increased by 3.4% and also in 2000 when the economy expanded by 3%). But on the whole the economy has avoided excessive growth of demand which can cause inflation.

Part of the reason for this has been the management of aggregate demand using monetary policy by the independent Bank of England. They have kept the output gap to very low levels (indicating an economy close to macroeconomic equilibrium) whilst a combination of other favourable factors on the demand and supply side of the economy has contributed to low inflation. In the absence of a major external inflationary shock from the global economy, there is every reason to believe that the British economy can continue to enjoy a combination of steady growth and low inflation. But this requires the supply-side of the economy to continue to deliver higher levels of productivity and investment to give the economy the productive capacity to meet demand and to maintain the competitiveness of UK producers in global markets.

 

Economic Growth and the Balance of Payments

Is there a trade off between fast economic growth and a worsening of the balance of trade in goods and services?

Arguments for the trade-off

When aggregate demand is high and domestic producers are unable to meet all of this demand, so the demand for imported goods and services will increase leading to an increase in the trade deficit. This trade-off is evident when the main source of rising AD is a high level of consumer spending. British consumers have a high propensity to import goods and services. As their incomes increase, so too does their demand for imports. The trade-off is worsened by the lack of international competitiveness of many UK industries compared to other leading countries.

The experience of the UK in recent years shows that the size of the trade deficit is largely cyclical. The strong growth of GDP and consumer demand has led to a large increase in the trade deficit in goods and services. This suggests that if the government wants to reduce the trade deficit, then it must accept that consumer demand (and GDP) must eventually grow at a slower rate in order to reduce the imbalance between exports and imports.
 
Counter-arguments

Economic growth can be achieved without a worsening of the balance of payments in goods and services. The causes of a trade deficit are not solely cyclical – there are structural explanations too – indeed in the long run, the main causes of imports out-pacing exports relate to the competitiveness of UK producers in their own domestic markets and when trying to export overseas.

Much depends on the strength of the exchange rate. When sterling is strong, the relative prices of imports coming into the UK falls, and British exports because more expensive in international markets – these causes a slowdown in export sales and a rise in the demand for imports. Depreciation in the exchange rate would provide a competitive boost to UK producers and might lead to an improvement in our balance of payments. However, a low exchange rate would also lead to an increase in the costs of imported goods and services risking higher “cost-push” inflation.

Exports can also be increased if our domestic industries increase their competitiveness in other ways: higher productivity helps to reduce unit costs; greater investment in new capital and research and development can lead to a faster pace of innovation and the development of new products in export sectors. Non-price competitiveness can also be improved by better design, after sales service, guaranteed delivery dates and more effective marketing.

Export-led growth (i.e. increases in aggregate demand brought about by an increase in the value of exported goods and services) can bring about economic growth without deterioration in a country’s trade balance.

A worsening of the trade balance in goods and services acts as a drag on short term economic growth for a country because imports are counted as a withdrawal from the circular flow of income and spending – so a surge in demand for overseas-produced goods and services leads to a flow of income and demand out of the economy.