Conflicts between macroeconomic objectives — Economics

Before this

This leads to

The Bank of England — roles and independence · coming soon
Monetary policy — effectiveness and limitations · coming soon
New Keynesian Phillips curve · coming soon

The best jobs figures in 48 years, and a crisis

In October 2022, the UK's Office for National Statistics (ONS) reported that unemployment was 3.5%, for June to August 2022. That was the lowest rate since 1974. On one of the four big goals of economic policy, the country was doing better than it had for almost half a century.

In the same month, consumer price inflation reached 11.1%, the highest in about 40 years. The Bank of England's target is 2%. Growth was close to zero.

So what should the Bank do? Raising interest rates fights inflation. But it also slows spending, and that costs jobs and growth. Cutting rates would help growth, but it would push inflation even higher. Every choice makes at least one goal worse.

This is not bad luck. The goals of macroeconomic policy often pull against each other. The last lecture warned that even a good supply-side policy can clash with other goals, and promised that this lecture would be about those clashes. Here they are.

Four goals, and which ones pull apart

Almost every government wants four things: strong, steady growth of real GDP, low and stable inflation (2% in the UK), low unemployment, and a sustainable current account. A sustainable current account is one that does not leave the country borrowing more and more from abroad.

Not every pair conflicts. Growth and low unemployment usually move together. When output grows, firms need more workers, and the costs-of-unemployment lecture linked the two with Okun's rule. The clashes come from the other pairs.

The four objectives. Numbered lines join the pairs that often conflict: (1) growth and inflation, (2) unemployment and inflation, (3) growth and the current account, (4) inflation and the current account. Growth and low unemployment usually move together.

Four conflicts matter most. Each one has a mechanism, and an exam answer should always state the mechanism, not just the clash.

1. Growth against inflation. When spending (aggregate demand) grows faster than the economy's capacity, firms cannot produce enough. They raise prices instead.
2. Low unemployment against low inflation. When few people are looking for work, workers can ask for bigger pay rises. Firms pass the higher costs on in prices.
3. Growth against the current account. Rising incomes are partly spent on imports.
4. Inflation against the current account. Faster inflation than abroad makes exports dearer.

Growth against inflation: the speed limit

The growth lecture separated two kinds of growth. Short-run growth uses spare capacity: idle machines and unemployed workers. Long-run growth raises capacity itself. An economy with spare capacity can grow fast without much inflation. But once the spare capacity is used up, more spending mostly raises prices.

This means every economy has a kind of speed limit. Over many years, output can grow only as fast as capacity grows, often estimated at roughly 1.5% to 2% a year in a rich country. If aggregate demand grows faster than that for long, inflation rises. Demand-side policy can bring the economy up to its speed limit; only supply-side policy can raise the limit. That is why the last lecture said supply-side policy "makes room" for growth without inflation.

Unemployment against inflation: the Phillips curve

In 1958 the economist A. W. (Bill) Phillips, born in New Zealand and working in London, published a study of UK data from 1861 to 1957. He compared the unemployment rate each year with the rate at which money wages rose. Years of low unemployment were years of fast wage rises. Years of high unemployment were years of slow wage rises, or even falling wages.

Notice that Phillips studied wages, not prices. Other economists soon redrew his curve with price inflation, because wages are the largest cost for most firms. In 1960 two American economists, Paul Samuelson and Robert Solow, described a curve like this as a "menu" for policy makers: choose less unemployment and accept more inflation, or the other way round.

A short-run Phillips curve (SRPC) for an invented economy. Moving from A (4% unemployment, 1.5% inflation) to B (3% unemployment, 3% inflation) trades lower unemployment for higher inflation.

The chain of reasons is the part to understand. Low unemployment means firms compete for scarce workers. Workers can ask for, and get, bigger pay rises. Higher wages raise firms' costs, and firms raise prices. So a movement from A to B, from 4% to 3% unemployment, comes with a rise in inflation from 1.5% to 3%. Today this downward-sloping line is called the short-run Phillips curve (SRPC).

For about ten years, many governments believed they could simply choose a point on this menu. Then it stopped working.

Why the menu stopped working

In the 1970s, many countries had high inflation and rising unemployment at the same time. This is stagflation. In the UK, the annual rise in the retail prices index reached 26.9% in August 1975, while the economy was in recession. On the old menu, that combination should not exist.

The explanation had already been given, in 1967 and 1968, by Edmund Phelps and Milton Friedman, working separately. Their key word was expectations.

Think about the chain again. Workers bargain over what their money will buy. If everyone expects 2% inflation, a 3% pay rise feels like a real gain. But suppose the government holds unemployment low, and inflation runs at 3% year after year. Soon workers expect 3%. Now they need about a 4% pay rise to feel any better off. Firms pass that on, and inflation rises again.

Each rise in expected inflation moves the whole short-run curve upwards. The same low unemployment now comes with more inflation than before. Holding unemployment below its natural rate does not buy a fixed amount of extra inflation. It buys inflation that keeps rising, year after year.

Try it in the model below. It is invented and simple: each point of unemployment below 5% adds one point to inflation, and people expect this year's inflation to repeat next year.

Simulate — holding unemployment below the natural rate

Choose the unemployment rate the government holds the economy at. Then press Next year, or Play, and watch inflation. Run it once with expectations that adjust, then once with expectations fixed at 2%.

Expectations:

Unemployment held at: 4%

This table shows the invented model with unemployment held at 4%, one point below the natural rate of 5%. Each point of unemployment below 5% adds one point to inflation above what people expect.

Year	Expected inflation (adjusting)	Inflation (adjusting)	Inflation (expectations stay at 2%)
1	2%	3%	3%
2	3%	4%	3%
3	4%	5%	3%
4	5%	6%	3%
5	6%	7%	3%

When expectations adjust, the same 4% unemployment brings inflation that rises every year. Only at 5% unemployment does inflation stay steady.

Did you see it? With expectations adjusting, holding unemployment at 4% does not give a steady 3% inflation. Inflation climbs by one point every year, and each year's curve sits higher than the last. Only at 5% does inflation stay steady, at whatever people expect. With expectations fixed at 2%, the old menu returns: 4% unemployment gives 3% inflation for ever.

That is it. That is the whole idea. In the long run, the trade-off disappears, because expectations catch up. The only unemployment rate consistent with steady inflation is the natural rate: the frictional and structural unemployment from the types-of-unemployment lecture. So the long-run Phillips curve (LRPC) is a vertical line at the natural rate. Some books call this rate the NAIRU, the non-accelerating inflation rate of unemployment; it comes from a slightly different theory, but at this level the two names point to the same idea.

The types-of-unemployment lecture promised that the policy lectures would return to this link between unemployment and inflation. This is that return. The model's last readout shows the cost of getting out again. Once people expect high inflation, bringing it back down needs unemployment above the natural rate for a while.

Stop and think

If the long-run Phillips curve is vertical, can a government ever lower unemployment for good?

Show the answer

Yes, but not with extra spending. It must lower the natural rate itself, by reducing frictional and structural unemployment. Better job matching, training for workers in declining industries, and help with moving to where the jobs are all do this. Those are supply-side policies. They move the vertical long-run curve to the left. This is the deepest link between this lecture and the last one: demand-side policy chooses where the economy sits; supply-side policy changes where it can sit.

Now test your understanding on a student's answer. One line contains the classic mistake.

Spot the error — "a fair price for lower unemployment"

The question was: "Unemployment is 5% and inflation is 2%. Should the government increase spending to bring unemployment down to 3%?" Tap the line that contains the error.

A student's answer, line by line. The error is in line 5.

Extra government spending raises aggregate demand, so firms produce more and hire more workers.
With fewer people looking for work, workers can bargain for bigger pay rises.
Firms pass the higher wage costs on in higher prices, so inflation rises, perhaps to about 4%.
This is a movement up the short-run Phillips curve.
The error: "So the country can keep unemployment at 3% for ever, as long as it accepts 4% inflation." This is wrong. Once workers expect 4% inflation, the curve shifts up, and inflation keeps rising.
A strong answer would also ask whether the 5% unemployment is cyclical or mainly structural.

Growth, inflation and the current account

The other two conflicts involve the rest of the world.

Growth against the current account. When a boom raises incomes, households spend part of each extra pound, dollar or rupee on imports. Exports depend on incomes abroad, which have not changed. So imports grow faster than exports, and the current account worsens. A policy that speeds up growth, such as a tax cut, often widens a current account deficit too.

Be careful with real numbers here. The UK's current account deficit widened sharply in 2022, a year that was not a boom. The main reason was that imported energy became much more expensive. The ONS first put the 2022 deficit at 3.1% of GDP, and later revised it to 2.1%. As the current account lecture showed, the cause decides whether a deficit is a problem.

Inflation against competitiveness. Suppose a country's prices rise by 6% a year, and its trading partners' prices rise by 2%, with no change in the exchange rate. After three years, its goods are dearer abroad by a factor of

(\frac{1.06}{1.02})^{3} \approx 1.122

That is about 12% dearer, though the goods themselves have not changed. Exports become harder to sell, and imports look cheaper at home. Under a floating exchange rate, the currency would usually fall over time and make up some of this gap. But a falling currency makes imports dearer, which raises inflation again.

A real case: the Bank of England chooses inflation, 2021–2024

The situation. In late 2021, UK inflation was rising fast, pushed first by reopening after the pandemic and then by energy and food prices after Russia's invasion of Ukraine in February 2022. Unemployment was very low. The economy was growing slowly.

The policy. The Bank of England's Monetary Policy Committee raised Bank Rate from 0.1% in December 2021, in fourteen steps, to 5.25% in August 2023.

The prediction. Higher rates would reduce spending, slowly. Inflation would come down, but the price would be weaker growth and higher unemployment, the conflicts of this lecture. Much of the inflation came from energy prices, which UK interest rates cannot change. The Bank's aim was to stop the high inflation from becoming built into expectations and pay deals, as it had in the 1970s.

What happened. CPI inflation fell from its peak of 11.1% in October 2022 to 2.0% in May 2024, helped a great deal by falling energy prices. The economy shrank a little in the third and fourth quarters of 2023, a shallow "technical recession", and growth for the whole of 2023 was later estimated at about 0.3%. Unemployment rose from 3.5% to about 4.4% in 2024.

The verdict. The Bank chose its priority, and inflation returned to target. Critics argue that rates rose too late at the start, and that falling energy prices did much of the work. Others argue that without the rises, expectations could have taken off, as in 1975. Economists still disagree about how much of the fall the rate rises caused. But there was no policy that could have protected all four goals at once.

Who should make the choice?

If every policy helps one goal and hurts another, someone must decide the priority. For monetary policy, many countries have given that decision to an independent central bank. The UK did this on 6 May 1997.

The main reason is the Phillips curve itself. A boom lowers unemployment first, and the inflation arrives later. So a government could be tempted to cut rates just before an election, and leave the inflation for afterwards. The American economist William Nordhaus described this temptation in 1975 as the political business cycle. A central bank with a clear inflation target, and no election to win, is more believable. When people believe it, their expectations stay "anchored" at the target, which keeps the short-run curve from drifting up.

There is a cost. The people who decide on interest rates are not elected, and a central bank told to target inflation may care less about unemployment than voters would like. Some, such as the US Federal Reserve, have a dual mandate: stable prices and maximum employment.

Worked examples

Worked Example 1 — Along the curve, then the curve moves (invented)

Country A has unemployment of 4% and inflation of 1.5%. The government increases spending. Unemployment falls to 3%, wages rise faster, and inflation rises to 3%. Explain what has happened, and what happens if 3% unemployment is held for several years.

First, this is a movement along the short-run Phillips curve, from A to B in the figure. Lower unemployment has been bought with higher inflation.

Next, people start to expect 3% inflation. Wage bargains build in 3% before they add anything for the tight labour market. The short-run curve shifts up. At 3% unemployment, inflation is now above 3%, and rising.

Then, to bring inflation back down, the central bank must push unemployment above the natural rate for a while.

Conclusion: the gain in jobs is temporary; the cost in inflation, and in the slowdown needed to cure it, is not.

Worked Example 2 — One shock, two kinds of conflict

Compare two invented countries. In Country P, spending suddenly falls: unemployment rises to 7% and inflation falls to 0.5%. In Country Q, the price of imported oil doubles: inflation rises to 8% while output falls and unemployment rises to 6%. In which country does the central bank face a real conflict?

Country P has a demand shock. All the goals point the same way. Cutting interest rates raises spending, which raises growth, lowers unemployment and lifts inflation back towards the target. There is no conflict for monetary policy.

Country Q has a supply shock. Inflation is too high, so the target says raise rates. Output is falling, so growth and jobs say cut them. Whatever the bank does, one goal gets worse.

Conclusion: conflicts between objectives are sharpest after supply shocks. That is exactly what happened in the 1970s oil shocks and again in 2022.

Three traps

Trap 1 — Treating the short-run curve as a permanent menu

The short-run Phillips curve describes a trade-off that lasts only until expectations catch up. In the long run, unemployment returns to the natural rate whatever inflation is chosen. Always say "in the short run" when you use the downward-sloping curve.

Trap 2 — Saying the goals always conflict

After a fall in demand, growth, jobs and inflation all call for the same policy. The conflicts are sharpest after supply shocks and when the economy is near full capacity. A strong answer names the cause of the problem before it names the conflict.

Trap 3 — Mixing up a movement and a shift

A change in unemployment caused by a change in spending is a movement along the short-run curve. A change in expected inflation, or a supply shock, shifts the curve. The same rule as for demand and supply curves: the variables on the axes move you along; anything else shifts the curve.

Try it yourself

Work each one on paper first. Open a hint only when you are stuck.

In an invented economy, the short-run Phillips curve is: inflation = expected inflation − 0.8 × (unemployment − 5). Expected inflation is 3%. Find inflation when unemployment is 4%, and when it is 6.5%.

Hint 1
Work out the bracket first: how far is unemployment from 5%?

Hint 2
For 4%: the bracket is −1, so subtract 0.8 × (−1), which adds 0.8.

Full answer
At 4%: $3 - 0.8 \times (4 - 5) = 3 + 0.8 = 3.8%$ . At 6.5%: $3 - 0.8 \times 1.5 = 3 - 1.2 = 1.8%$ . Check: lower unemployment gives higher inflation, and at exactly 5% inflation would equal the expected 3%.
In another invented economy, inflation = expected inflation − 0.5 × (unemployment − 5), and people expect last year's inflation to repeat. Inflation and expectations start at 2%. The government holds unemployment at 3% for three years. Find inflation in each year. Then find the unemployment rate needed in year 4 to bring inflation back to 2% in one step.

Hint 1
Each year, 0.5 × (3 − 5) = −1, so inflation is one point above what was expected.

Hint 2
In year 4, expected inflation is year 3's inflation. Solve 2 = expected − 0.5 × (u − 5) for u.

Full answer
Year 1: $2 + 1 = 3%$ . Year 2: $3 + 1 = 4%$ . Year 3: $4 + 1 = 5%$ . In year 4, people expect 5%. To get 2%: $2 = 5 - 0.5 (u - 5)$ , so $0.5 (u - 5) = 3$ , $u - 5 = 6$ and $u = 11%$ . Check: $5 - 0.5 \times 6 = 2$ . ✓ Three years of 2 points less unemployment need one year of 6 points more to undo, if it is done in one step. Real central banks spread the cure over several years, but the total cost is still large.
Country R has a fixed exchange rate. Its prices rise by 5% a year, while its trading partners' prices rise by 2% a year. By what percentage have its goods become dearer, relative to its partners', after four years? By how much would its currency need to fall to make up the difference?

Hint 1
Divide the two growth factors each year: 1.05 ÷ 1.02. Then raise the result to the power 4.

Hint 2
If goods are dearer by a factor k, the currency must fall to 1/k of its old value.

Full answer
$(1.05 \div 1.02)^{4} \approx 1.123$ , so its goods are about 12.3% dearer. To undo this, the currency must fall to $1 \div 1.123 \approx 0.891$ of its old value, a fall of about 10.9%. Check: $1.123 \times 0.891 \approx 1.00$ . Notice that the needed fall (10.9%) is smaller than the rise (12.3%), because the two percentages are of different starting amounts.
An invented country imports most of its energy. World energy prices jump. Inflation rises to 9%, output starts to fall, unemployment is 4% but rising, and the current account deficit widens. Write a short evaluation: should the central bank raise interest rates?

Hint 1
Is this a demand shock or a supply shock? What does each goal call for?

Hint 2
Think about expectations. What would make the case for raising rates stronger, and what would make it weaker?

Full answer
This is a supply shock, so the goals conflict. Inflation calls for higher rates; falling output and rising unemployment call for lower rates. Higher rates cannot lower world energy prices, so they would cut inflation mainly by squeezing spending, at a cost in jobs.
The case for raising rates is strongest if there are signs that high inflation is spreading into wage bargains and expectations: then waiting risks a 1970s-style spiral that is much costlier to stop later. The case is weaker if energy prices are expected to fall back soon and wage growth stays moderate, so the inflation fades by itself. The current account deficit points the same way as inflation, because higher rates reduce spending on imports and may raise the currency. A good conclusion names the priority and the evidence that would change it, for example "raise rates moderately, and stop if wage growth stays below 4%".

The bigger idea

Economics is often called the study of choices under scarcity. This lecture shows that the same is true for a whole economy. A government cannot have everything at once, so it must choose a priority, and the right choice depends on the cause of the problem: demand or supply, temporary or lasting.

The deepest lesson is about time. The Phillips curve offers something now and sends the bill later. Good policy sees the later bill, and builds institutions, such as an independent central bank with a clear target, that make the offer easier to resist.

Key concepts in this lesson

The main conflicts are growth against inflation, low unemployment against low inflation, growth against the current account, and inflation against competitiveness, while growth and low unemployment usually move together.
The short-run Phillips curve slopes down because low unemployment lets workers win bigger pay rises, which firms pass on in prices.
When expected inflation rises, the short-run curve shifts up, so holding unemployment below the natural rate brings inflation that keeps rising.
The long-run Phillips curve is vertical at the natural rate of unemployment, which only supply-side policy can lower.
Independent central banks with an inflation target are meant to resist the short-run temptation to boost the economy before elections, at some cost in democratic accountability.