IB DP Economics - Unit 3 - Potential conflict between macroeconomic objectives-Study Notes - New Syllabus

Potential Conflict Between Macroeconomic Objectives: Low Unemployment and Low Inflation

Governments aim to achieve several macroeconomic objectives, including:

• Low unemployment
• Low and stable inflation
• Economic growth
• External stability

However, these objectives may sometimes conflict with each other.

One important conflict occurs between low unemployment and low inflation.

Why Reducing Unemployment May Increase Inflation

To reduce unemployment, governments may use:

• Expansionary fiscal policy
• Expansionary monetary policy

These policies increase aggregate demand (AD).

Higher AD → Higher output → Higher employment

As firms increase production, they hire more workers.

This reduces cyclical unemployment.

Inflationary Pressure

If aggregate demand rises rapidly:

• Consumer spending increases.
• Demand for goods and services rises.
• Firms may increase prices.
• Wages and production costs may also rise.

Result:

Inflationary pressure increases.

Lower unemployment → Higher inflationary pressure

Example

Suppose the government increases infrastructure spending during a recession.

Possible Effects:

• Construction firms hire more workers.
• Household incomes increase.
• Consumer spending rises.
• Aggregate demand increases.

However, if demand rises too quickly, firms may raise prices, causing inflation.

Why Reducing Inflation May Increase Unemployment

To reduce inflation, governments may use:

• Contractionary fiscal policy
• Contractionary monetary policy

Examples:

• Higher taxes
• Lower government spending
• Higher interest rates

These policies reduce aggregate demand.

Lower AD → Lower output → Lower inflationary pressure

Effects on Employment

When aggregate demand falls:

• Firms reduce production.
• Businesses may hire fewer workers.
• Some workers may lose jobs.

Result:

Unemployment may increase.

Lower inflation → Higher unemployment

Why the Conflict Exists

The conflict exists because:

• Policies increasing aggregate demand reduce unemployment but may increase inflation.
• Policies reducing aggregate demand lower inflation but may reduce employment and growth.

Governments therefore need to balance the two objectives carefully.

Role of Supply-Side Policies

Supply-side policies may help reduce the conflict between low unemployment and low inflation.

Examples:

• Education and training
• Infrastructure investment
• Improved productivity
• Labor market reforms

Possible Effects:

• Increase productive capacity.
• Improve efficiency.
• Reduce inflationary pressure.
• Create employment opportunities.

These policies may help achieve both objectives together in the long run.

Comparison of Expansionary and Contractionary Policies:

Evaluation

• Expansionary policies may successfully reduce unemployment during recessions.
• However, excessive aggregate demand may create inflationary pressure.
• Policies used to reduce inflation may slow economic growth and increase unemployment.
• The seriousness of the conflict depends on economic conditions and the level of spare capacity in the economy.
• Supply-side policies may help reduce the trade-off in the long run.

Trade-Off Between Unemployment and Inflation (HL only)

The trade-off between unemployment and inflation refers to the relationship where attempts to reduce unemployment may lead to higher inflation, while attempts to reduce inflation may increase unemployment.

This relationship is explained using the Phillips curve.

The Phillips curve shows the relationship between:

• The rate of unemployment
• The rate of inflation

The Short-Run Phillips Curve (SRPC)

The short-run Phillips curve shows an inverse relationship between unemployment and inflation in the short run.

Meaning:

• Lower unemployment is associated with higher inflation.
• Higher unemployment is associated with lower inflation.

The curve is downward sloping.

Why the Trade-Off Exists in the Short Run

When aggregate demand increases:

• Firms increase production.
• More workers are hired.
• Unemployment falls.

As labor demand increases:

• Wages begin to rise.
• Production costs increase.
• Prices rise.

Result:

Lower unemployment → Higher inflation

AD/AS Explanation of the Short-Run Trade-Off

The trade-off can also be explained using the AD/AS model.

When aggregate demand shifts right:

• Real output increases.
• Employment increases.
• Unemployment falls.
• The price level rises.

This creates demand-pull inflation while reducing cyclical unemployment.

Diagram (HL only):

AD/AS diagram showing a rightward shift of AD causing higher price level and higher real output.

The Long-Run Phillips Curve (LRPC)

The long-run Phillips curve shows that in the long run there is no permanent trade-off between unemployment and inflation. 

The curve is vertical at the natural rate of unemployment.

Natural Rate of Unemployment

The natural rate of unemployment is the unemployment rate that exists when the economy is operating at full employment.

It includes:

• Frictional unemployment
• Structural unemployment

It does not include cyclical unemployment.

Why the Trade-Off Disappears in the Long Run

In the long run, workers and firms adjust their inflation expectations.

Explanation:

• Suppose expansionary policies reduce unemployment below the natural rate.
• Inflation rises.
• Workers begin expecting higher inflation.
• Workers demand higher wages.
• Production costs rise further.

Result:

• The short-run Phillips curve shifts upward.
• Unemployment returns to the natural rate.
• Inflation remains higher.

Therefore, attempts to keep unemployment below the natural rate only create higher inflation in the long run.

Shift of the Short-Run Phillips Curve

The SRPC may shift because of changes in:

• Inflation expectations
• Supply shocks
• Commodity prices
• Labor productivity

Supply Shock Example

A rise in oil prices increases production costs.

Effects:

• Inflation increases.
• Unemployment also increases.

This causes the short-run Phillips curve to shift upward/right.

Stagflation

Stagflation occurs when:

• Inflation is high
• Unemployment is high
• Economic growth is low

Stagflation challenges the simple short-run Phillips curve relationship.

Role of Supply-Side Policies

Supply-side policies may reduce the natural rate of unemployment.

Examples:

• Education and training
• Labor market reforms
• Improved labor mobility

Effects:

• Natural rate of unemployment falls.
• Long-run Phillips curve shifts left.
• The economy may achieve lower unemployment without higher inflation.

Comparison Between the Short-Run and Long-Run Phillips Curve:

Evaluation

• The short-run Phillips curve suggests policymakers face a temporary trade-off between unemployment and inflation.
• The long-run Phillips curve suggests that this trade-off disappears over time.
• Inflation expectations are important in determining long-run outcomes.
• Supply shocks and stagflation show that inflation and unemployment may rise together.
• Supply-side policies may reduce the natural rate of unemployment without increasing inflation.