2.6.4 Conflicts and tradeoffs between objectives and policies

Conflicts and Trade-offs

1. Most conflicts arise because the economy has finite productive capacity in the short run: near full capacity extra demand mainly raises prices, whereas with spare capacity several objectives can improve together for a time.

Conflicting Objectives

1. Lower unemployment often conflicts with low inflation, because rising demand for labour bids up wages and prices.
2. Faster growth can worsen the current account, as higher incomes pull in more imports, and can conflict with protecting the environment through more pollution and use of finite resources.
3. Greater income equality can conflict with growth if high taxes and generous benefits weaken incentives to work and invest, while cutting a fiscal deficit through consolidation can slow growth and raise unemployment in the short run.

The Short-run Phillips Curve

1. On the diagram, unemployment is on the horizontal axis and inflation on the vertical axis, and a rise in aggregate demand moves the economy along the SRPC to lower unemployment but higher inflation.
2. The trade-off holds only in the short run: once workers expect higher inflation and wages catch up, the SRPC shifts and unemployment returns to the natural rate, so the LRPC is vertical.

Policy Conflicts

1. Policies conflict because a policy aimed at one objective can move another the wrong way.
2. Contractionary policy to cut inflation tends to raise unemployment and slow growth, while expansionary policy to cut unemployment can widen the current account deficit and add to inflation.
3. Supply-side policy can ease some conflicts over time by raising capacity, though it works slowly and its outcome is uncertain.

Can all the objectives be met at once?

1. It can hold with spare capacity, for example after a recession, when growth, jobs and low inflation improve together, and successful supply-side reform can shift the whole trade-off in a favourable direction.
2. But near full capacity the short-run Phillips curve shows lower unemployment comes only with higher inflation, and faster growth tends to worsen the current account and the environment.
3. Demand-side tools can only shift aggregate demand, so they cannot resolve a supply-constrained conflict on their own.
4. On balance it depends on spare capacity, the time horizon and whether supply-side reform succeeds, so in the short run trade-offs are usually unavoidable.