Published by Patrick Mutisya · 14 days ago
In the short run many economies experience a tension between two of the principal macro‑economic objectives:
Government policy must often choose between, or try to balance, these aims. The following notes outline why the conflict arises, the theoretical background, and the policy options available to governments.
The position of the economy in the AD–AS diagram determines both the output (employment) level and the price level.
The short‑run Phillips curve shows an inverse relationship between the unemployment rate (\$u\$) and the inflation rate (\$\pi\$):
\$\pi = \pi^{e} - \beta (u - u^{*})\$
where \$\pi^{e}\$ is expected inflation, \$u^{*}\$ is the natural rate of unemployment and \$\beta > 0\$.
In the long run the Phillips curve is vertical at \$u^{*}\$, implying no permanent trade‑off – but the short‑run trade‑off is the source of policy conflict.
Occurs when AD outstrips the economy’s productive capacity. Typical triggers include:
Arises from increases in production costs, shifting the short‑run AS curve left. Common causes:
Cost‑push inflation can raise prices even when unemployment is already high, making the conflict more acute.
| Policy tool | Typical effect on employment | Typical effect on inflation | Notes / potential conflict |
|---|---|---|---|
| Expansionary fiscal policy (increase G or cut taxes) | ↑ Aggregate demand → ↑ output → ↓ unemployment | ↑ Aggregate demand → ↑ price level → ↑ inflation | Effective when there is spare capacity; risk of demand‑pull inflation if economy near full capacity. |
| Contractionary fiscal policy (decrease G or raise taxes) | ↓ Aggregate demand → ↓ output → ↑ unemployment | ↓ Aggregate demand → ↓ price level → ↓ inflation | Used to combat high inflation; may raise unemployment. |
| Expansionary monetary policy (lower interest rates, QE) | ↓ borrowing costs → ↑ investment & consumption → ↓ unemployment | ↑ spending → ↑ price level → ↑ inflation | Transmission lag; can fuel asset‑price bubbles. |
| Contractionary monetary policy (higher rates, sell securities) | ↑ borrowing costs → ↓ investment & consumption → ↑ unemployment | ↓ spending → ↓ price level → ↓ inflation | Often the first response to high inflation; may depress growth. |
| Supply‑side measures (e.g., training, deregulation, tax incentives for R&D) | ↑ productivity → ↑ potential output → ↓ structural unemployment | ↑ potential output shifts AS right → ↓ price level for a given AD | Can improve both aims in the long run, but effects are gradual. |
| Wage and price controls | May temporarily protect employment | Directly limit price rises | Often lead to shortages, black markets, and reduced incentives to produce. |
Governments typically adopt a combination of demand‑side and supply‑side policies to try to achieve both aims:
After a period of high inflation in the 1970s and 1980s, the UK government pursued a tight monetary policy to bring inflation down. This raised unemployment in the short run, illustrating the classic conflict. Later, supply‑side reforms (privatisation, deregulation) helped increase potential output, allowing lower unemployment without reigniting inflation.