Macroeconomic Objectives Often Conflict, so Improving One Can Worsen Another

1. Governments pursue several macroeconomic objectives at once: strong and sustainable economic growth, low and stable inflation, low unemployment, a satisfactory position on the current account of the balance of payments, and increasingly an environmentally sustainable economy.
2. These goals cannot always be met together.
3. Using demand-side policy to advance one objective frequently sets back another, which is why policymakers must weigh trade-offs and decide which target to prioritise.

Output Gaps Link Unemployment to Inflationary Pressure

1. A negative output gap occurs when real output is below the productive potential of the economy.
2. Spare capacity means cyclical unemployment is high and there is little upward pressure on wages and prices, so inflationary pressure is weak.
3. A positive output gap occurs when real output is pushed above its sustainable trend.
4. The economy is stretched, unemployment is low, and firms bid for scarce labour and materials, so demand-pull and cost-push inflationary pressure builds.
5. This relationship between the output gap, unemployment and inflation is the foundation of the Phillips curve.

The Short-Run Phillips Curve Shows a Trade-Off Between Inflation and Unemployment

1. The short-run Phillips curve plots the rate of unemployment on the horizontal axis against the rate of inflation on the vertical axis.
2. It slopes downward, so lower unemployment tends to coincide with higher inflation, and vice versa.
3. The relationship reflects the pressure of aggregate demand on wages and prices: as rising demand pulls unemployment down towards full capacity, inflation accelerates.

The Long-Run Phillips Curve Is Vertical, so There Is No Lasting Trade-Off

1. In the long run the Phillips curve is vertical at the natural rate of unemployment, the NAIRU or non-accelerating inflation rate of unemployment (AQA also describes it as the long-run, L-shaped Phillips curve).
2. Because it is vertical, there is no long-run trade-off between inflation and unemployment: the economy settles at the natural rate whatever the rate of inflation.
3. The natural rate is a supply-side equilibrium, not zero unemployment, because frictional and structural unemployment always remain.
4. If demand-side policy holds unemployment below the natural rate, inflation first rises.
5. Workers then come to expect higher inflation and bargain for higher wages, raising firms' costs.
6. Unemployment drifts back to the natural rate, but now with permanently higher inflation.
7. Attempts to exploit the short-run trade-off therefore only ratchet inflation upwards over time.

Policy Can Reconcile Conflicts Differently in the Short Run and the Long Run

1. In the short run, demand-management policy moves the economy along the short-run Phillips curve.
2. A government can accept slightly higher inflation to bring unemployment down, or tighten policy to reduce inflation at the cost of higher unemployment.
3. The choice depends on which objective is given priority, and the trade-off, though real, is only temporary.
4. In the long run, the conflict between low unemployment and low inflation can only be eased by supply-side policy.
5. Better education and training, stronger job-search support and a more flexible labour market lower the natural rate of unemployment and shift the long-run Phillips curve to the left.
6. This allows lower unemployment to coexist with stable inflation, reconciling the two objectives rather than simply raising inflation.

Faster Economic Growth Can Conflict With Low Inflation

1. Demand-led growth raises aggregate demand.
2. As the economy approaches full capacity and a positive output gap opens, demand-pull inflation builds and firms face rising input costs.
3. Rapid growth driven by consumer and government spending therefore tends to conflict with the objective of low and stable inflation, which is why a central bank may raise interest rates to cool an overheating economy even though this slows growth.

Faster Growth Can Worsen the Current Account of the Balance of Payments

1. When incomes rise during a period of strong growth, households spend more, and a large share of that extra spending goes on imported goods and services.
2. If import spending rises faster than exports, the current account deficit widens.
3. Strong domestic growth can therefore conflict with the objective of a satisfactory balance of payments, particularly where the marginal propensity to import is high.

Growth Can Conflict With Environmental Sustainability and a Fairer Income Distribution

1. Higher output usually means greater use of energy and raw materials and more pollution.
2. These negative externalities, including carbon emissions and resource depletion, mean rapid growth can conflict with environmental objectives and long-run sustainability.
3. Growth can also widen income inequality if its gains flow mainly to owners of capital and to highly skilled workers, so a government pursuing faster growth may need green or redistributive policies to limit these side effects.

The Phillips Curve Is a Useful but Limited Guide for Policy

1. In favour of the model, there is a genuine short-run demand-side trade-off: lower unemployment does tend to come with higher inflation.
2. The curve links neatly to the AD-AS model and the output gap, giving policymakers a clear way to picture the tension between the two objectives.
3. Against it, the stable relationship broke down in the 1970s, when high inflation and high unemployment, or stagflation, occurred together.
4. Because inflation expectations shift the short-run curve, and because the economy returns to the natural rate in the long run, the trade-off is unstable and cannot be relied on to deliver a lasting fall in unemployment.
5. On balance, the Phillips curve is a useful short-run guide, but shifting expectations and the vertical long-run curve mean demand policy alone cannot secure lower unemployment without accelerating inflation.
6. Lasting improvement requires supply-side reform.