relationship between growth and inflation

Links between Macro‑economic Problems and Their Inter‑relatedness (Cambridge AS & A Level Economics 9708)

1. Government Macro‑economic Policy Objectives (Syllabus 10.1)

Governments aim to achieve a balanced set of objectives. Each objective is measured with a specific indicator and has a clear economic rationale.

2. Quick‑Reference AS‑Level Macro‑economy (Foundations for A‑Level)

This box summarises the core concepts that underpin the A‑Level inter‑relationships.

• National‑income accounting: Real GDP (Y) = C + I + G + (X‑M). Measured in constant prices to remove inflation effects.
• Aggregate‑demand (AD) curve: Shows the relationship between the price level (P) and total demand for goods and services (Y). Downward‑sloping in (P, Y) space.
• Aggregate‑supply (AS) curves:
  • Short‑run AS (SRAS) – upward sloping; output depends on the price level.
  • Long‑run AS (LRAS) – vertical at potential output (Y*), determined by technology, capital, labour, and institutions.
• Unemployment:
  • Frictional, structural, cyclical.
  • Natural rate of unemployment (u*) = frictional + structural.
• Inflation:
  • Demand‑pull (excess AD) vs. cost‑push (higher input costs).
  • Measured by %ΔP (CPI or RPI).
• Exchange rates:
  • Nominal exchange rate (E): domestic currency per unit of foreign currency.
  • Real exchange rate (RER) = (E × P*) / P.
• Balance of Payments (BoP):
  • Current account (trade in goods & services, income, transfers) + capital/financial account = 0 (by definition).

3. Key Concepts (used throughout the syllabus)

• Economic Growth: Increase in real output over time. g = ΔY / Y.
• Inflation: Sustained rise in the general price level. π = ΔP / P.
• Unemployment: Share of the labour force that is job‑seeking but not employed.
• Balance of Payments (BoP): Record of all economic transactions with the rest of the world.
• Internal value of money: Purchasing power of the domestic currency (inverse of the price level).
• External value of money: Value of the domestic currency in foreign‑exchange markets (exchange rate).

4. Required Inter‑relationships (Syllabus 10.2)

4.1 Growth ↔ Inflation (10.2.1)

Short‑run link

• AD shifts right → higher output (Y) and higher price level (P). Positive correlation.
• Illustrated by the upward‑sloping segment of the Phillips curve:
  π = π⁽ᵉ⁾ – β (u – u*), β > 0.
• Policy example: Expansionary fiscal policy (higher G) raises AD, boosting g but may generate demand‑pull inflation if the economy is near Y*.

Long‑run link

• LRAS is vertical at potential output Y*; Y* is set by real factors (technology, capital, labour, institutions).
• Long‑run Phillips curve is vertical: π = π⁽ᵉ⁾. No sustainable trade‑off – higher inflation does not raise Y*.
• Supply‑side improvements (e.g., better education) shift LRAS right, allowing higher g without raising π.

Diagram required: AD–AS model showing a rightward AD shift (short‑run) and a vertical LRAS (long‑run).

4.2 Inflation ↔ Unemployment (10.2.2)

• Short‑run Phillips curve (expectations fixed): inverse relationship – lower u ↔ higher π.
• Expectations‑augmented Phillips curve: if workers expect higher inflation, the curve shifts upward; the trade‑off shrinks.
• Long‑run Phillips curve: vertical at the natural rate of unemployment u*; no permanent trade‑off.

Diagram required: Phillips curve with short‑run downward‑sloping segment, upward shift due to higher expectations, and a vertical long‑run line at u*.

4.3 Internal Value of Money ↔ External Value of Money (Exchange‑rate link) (10.2.3)

• Real exchange rate: RER = (E × P*) / P.
  • Depreciation (rise in E) → higher RER → exports become cheaper, imports more expensive → AD shifts right → higher g, but imported inflation may rise.
  • Appreciation (fall in E) → lower RER → export competitiveness falls → AD shifts left → lower g, but cheaper imports help contain inflation.

Diagram required: Real‑exchange‑rate effect on AD – a depreciation moves AD right, an appreciation moves it left.

4.4 Balance of Payments ↔ Inflation (10.2.4)

• Demand‑pull inflation: AD rightward shift raises imports, worsening the current‑account balance.
• Cost‑push inflation: Higher input costs (e.g., oil) raise production costs and the price of imported inputs, widening the trade deficit.
• Imported inflation: Currency depreciation raises the domestic price of imported goods, feeding directly into CPI.

Diagram required: BoP diagram showing how a demand‑pull inflationary gap can turn a current‑account surplus into a deficit (shift of the import curve).

4.5 Growth ↔ Balance of Payments (10.2.5)

• Export‑led growth: Higher X raises export earnings, improving the current account.
• Rapid domestic demand growth: If domestic consumption outpaces export capacity, imports rise faster than exports → current‑account deficit.
• Terms‑of‑trade effect: An improvement (higher export prices relative to import prices) can support both higher g and external balance.

Diagram required: Growth‑BoP diagram – an outward shift in the export curve improves the current account, while an outward shift in the import curve can offset it.

5. Effectiveness of Policy Options (Syllabus 10.3)

Each policy influences one or more of the six macro‑objectives and may create trade‑offs with the others. The table below maps the main policy tools to the objectives they affect and highlights typical conflicts.

6. Additional A‑Level Content (for completeness)

6.1 Money & Banking (Syllabus 9.1‑9.4)

• Functions of money: medium of exchange, unit of account, store of value.
• Money creation process: reserve ratio, multiplier (M = m × R).
• Roles of the central bank: monetary policy implementation, lender of last resort, managing foreign‑exchange reserves.
• Monetary policy transmission mechanisms: interest‑rate channel, credit channel, exchange‑rate channel.

6.2 Full Set of Government Macro‑policy Objectives (Syllabus 10.1 – expanded)

Beyond the six objectives listed earlier, the A‑Level syllabus expects students to understand the *inter‑relationships* and *conflicts* among them, especially how fiscal and monetary policies can be coordinated to achieve a balanced outcome.

6.3 International Macro‑issues (Syllabus 11.1‑11.5)

• Exchange‑rate regimes: fixed, floating, managed float; advantages & disadvantages.
• Balance‑of‑payments sustainability: current‑account deficits, capital‑account surpluses, and the role of foreign‑direct investment.
• Development indicators: Human Development Index (HDI), Gini coefficient, poverty rates; how macro‑policy can influence them.
• Globalisation and policy coordination: impact of multinational corporations, trade blocs, and IMF/World Bank programmes.

7. Suggested Diagrams (required for exam answers)

• AD–AS model: short‑run AD rightward shift (growth‑inflation trade‑off) and vertical LRAS (long‑run independence).
• Phillips curve: short‑run downward‑sloping segment, expectations‑augmented upward shift, and vertical long‑run line at u*.
• Real‑exchange‑rate diagram: depreciation shifts AD right; appreciation shifts AD left.
• Balance‑of‑Payments diagram: import curve shifts with inflation, showing current‑account deficit/surplus outcomes.
• Growth‑BoP diagram: export and import curves illustrating export‑led growth versus demand‑pull current‑account deficits.

8. Summary

In the short run, growth and inflation move together because changes in aggregate demand affect both output and the price level. The Phillips curve captures the accompanying trade‑off with unemployment. In the long run, the economy operates at its potential output (LRAS), so sustained inflation does not raise real growth; supply‑side improvements are the only way to shift Y* rightward.

The five mandatory inter‑relationships (growth‑inflation, inflation‑unemployment, internal‑external value of money, BoP‑inflation, growth‑BoP) demonstrate how a policy decision in one area reverberates across the whole macro‑economy, creating both opportunities and conflicts among the six government objectives. Effective policymaking therefore requires a careful assessment of short‑run impacts, long‑run sustainability, and the inevitable trade‑offs between price stability, employment, growth, external balance, fiscal health, and equity.