Government macro‑economic intervention – conflicts between full employment and stable prices
1. The six principal macro‑economic aims (Cambridge IGCSE 0455)
Cambridge expects students to recognise that macro‑economic policy seeks to achieve the following aims, often simultaneously:
| Aim | What it means |
|---|
| Full employment | Minimise unemployment and make the best use of labour resources. |
| Stable prices | Keep inflation low, predictable and under control. |
| Economic growth | Raise real GDP and improve living standards over time. |
| Balance‑of‑payments stability | Avoid large, persistent current‑account deficits or surpluses. |
| Redistribution of income | Reduce inequality through taxes, transfers and public services. |
| Environmental sustainability | Protect natural resources and limit pollution while the economy grows. |
1.1 Typical conflicts between the aims
- Full employment ↔ Stable prices – Raising output can generate demand‑pull inflation.
- Economic growth ↔ Environmental sustainability – Rapid growth may increase carbon emissions and resource depletion.
- Full employment ↔ Balance‑of‑payments stability – Higher domestic demand can raise imports, widening the current‑account deficit.
- Redistribution ↔ Economic growth – High marginal tax rates may discourage investment and slow growth.
2. Why a short‑run conflict arises between full employment and stable prices
2.1 AD–AS framework
- Aggregate demand (AD) = C + I + G + (X − M). A right‑hand shift raises real output and reduces unemployment.
- Short‑run aggregate supply (SRAS) shows the quantity firms are willing to produce at each price level.
- If the economy is operating below potential output, an increase in AD raises both output and the price level – a classic case of demand‑pull inflation.
- When the economy is close to full capacity, most of the AD shift is absorbed by higher prices, so inflation rises sharply while extra output is limited.
2.2 The short‑run Phillips curve
The inverse relationship between unemployment (u) and inflation (π) is expressed as:
\$\pi = \pi^{e} - \beta\,(u - u^{*})\$
- πe = expected inflation.
- u* = natural (long‑run) rate of unemployment.
- β > 0 measures how strongly a fall in unemployment pushes up inflation.
In the short run, moving the economy below u* (lower unemployment) tends to raise inflation; keeping inflation low by accepting u > u* raises joblessness. In the long run the curve is vertical at u*, indicating no permanent trade‑off.
3. Sources of inflation that aggravate the trade‑off
3.1 Demand‑pull inflation
- Expansionary fiscal policy – higher government spending (G) or tax cuts.
- Expansionary monetary policy – lower policy interest rates, quantitative easing.
- Strong consumer confidence, a boom in exports or a rise in asset‑price wealth.
3.2 Cost‑push inflation
- Wage increases that outpace productivity.
- Higher raw‑material or energy prices (e.g., oil shocks).
- Supply‑side disruptions such as natural disasters, geopolitical events or pandemic‑related bottlenecks.
Cost‑push inflation can raise the price level even when unemployment is already high, deepening the policy dilemma.
4. Fiscal policy – tools, effects and the macro‑policy mix
4.1 Government budget basics
- Budget balance = Government spending (G) – Tax revenue (T).
- Deficit when G > T (financed by borrowing).
- Surplus when G < T (used to reduce debt or build reserves).
4.2 Main types of taxation
| Tax type | Key feature | Typical macro effect |
|---|
| Progressive income tax | Higher rates on higher incomes | Reduces disposable income of high earners → contractionary; improves income equality. |
| Regressive indirect tax (VAT, sales tax) | Same rate on all consumption | Raises price of goods → can be mildly contractionary; burden falls proportionally more on low‑income households. |
| Corporate tax | Levied on profits | Higher rates may discourage investment → contractionary; lower rates can stimulate capital formation. |
| Excise duties | Target specific goods (fuel, tobacco, alcohol) | Raise prices of targeted goods → can curb consumption and raise revenue. |
4.3 Fiscal policy instruments
- Expansionary fiscal policy – increase G or cut taxes → AD ↑ → output ↑, unemployment ↓, price level ↑ (risk of demand‑pull inflation).
- Contractionary fiscal policy – decrease G or raise taxes → AD ↓ → output ↓, unemployment ↑, price level ↓ (used to fight high inflation).
- Automatic stabilisers – tax‑transfer system (e.g., progressive income tax, unemployment benefits) that automatically dampen fluctuations without active policy changes.
4.4 Interaction with the other aims
| Policy move | Effect on full employment | Effect on stable prices | Implications for other aims |
|---|
| Increase G (in a recession) | ↓ unemployment | ↑ inflation risk | May widen current‑account deficit; can be progressive if targeted at public services. |
| Raise income tax rates | ↑ unemployment (reduced demand) | ↓ inflation pressure | Improves redistribution but can slow growth. |
| Introduce a carbon tax | Neutral/short‑run ↑ unemployment (higher costs) | ↑ price level (cost‑push) | Promotes environmental sustainability; revenue can fund green investment. |
5. Monetary policy – tools, expectations and the Phillips curve link
- Policy interest rate – central bank’s main instrument; lower rates reduce borrowing costs, boost investment and consumption, but can fuel inflation.
- Open‑market operations (OMO) – buying or selling government securities to change the money supply.
- Quantitative easing (QE) – large‑scale asset purchases when short‑term rates are already low; lowers long‑term rates and raises asset prices.
- Exchange‑rate interventions – buying or selling foreign currency to influence import prices and the current account.
- Inflation targeting – public commitment to a specific inflation rate (e.g., 2 %). Improves credibility, anchors expectations and reduces the upward pressure on wages and prices when unemployment falls.
5.1 Monetary policy and the Phillips curve
By influencing expected inflation (πe), a credible inflation target can shift the short‑run Phillips curve downwards, allowing lower unemployment for a given inflation rate.
6. Supply‑side measures – shifting LRAS right
- Human capital development – investment in education, training, apprenticeships → higher labour productivity.
- Deregulation & competition policy – reduces barriers to entry and lowers production costs.
- Tax incentives for R&D and capital formation – encourage innovation and investment in plant & equipment.
- Infrastructure investment – transport, digital networks, energy grids lower transaction costs.
- Environmental policies that promote green technology – carbon pricing, subsidies for renewables; may raise short‑run costs but raise long‑run potential output.
When LRAS shifts right, the same level of AD can deliver higher output and lower unemployment without increasing the price level – a win‑win for the two core aims.
7. Summary table – typical impact of each policy tool
| Policy tool | Typical effect on employment | Typical effect on inflation | Key advantage / risk |
|---|
| Expansionary fiscal policy (↑G or ↓T) | ↑ output → ↓ unemployment | ↑ AD → ↑ price level | Effective with spare capacity; risk of demand‑pull inflation near full capacity. |
| Contractionary fiscal policy (↓G or ↑T) | ↓ output → ↑ unemployment | ↓ AD → ↓ price level | Useful to curb high inflation; may hurt growth and increase deficit‑reduction pressure. |
| Expansionary monetary policy (↓interest rates, QE) | ↓ borrowing costs → ↑ investment & consumption → ↓ unemployment | ↑ spending → ↑ price level | Fast transmission but lags; can create asset‑price bubbles. |
| Contractionary monetary policy (↑interest rates, sell securities) | ↑ borrowing costs → ↓ investment & consumption → ↑ unemployment | ↓ spending → ↓ price level | First line of defence against inflation; may depress growth. |
| Supply‑side reforms (training, deregulation, R&D incentives) | ↑ productivity → ↓ structural unemployment | ↑ potential output shifts LRAS right → ↓ price level for a given AD | Improves both aims in the long run; effects are gradual. |
| Wage and price controls | May temporarily protect jobs | Directly limit price rises | Often cause shortages, black markets and reduced incentives to produce. |
8. Managing the trade‑off – a coherent policy mix
- Stabilise demand – Use moderate, timely fiscal or monetary adjustments to keep AD close to potential output.
- Boost supply – Implement structural reforms that shift LRAS right, allowing higher output without triggering inflation.
- Anchor expectations – Adopt a credible inflation target and communicate policy intentions clearly.
- Coordinate fiscal and monetary actions – Ensure the two are consistent (e.g., fiscal consolidation when monetary policy is already tight).
- Take secondary aims into account – Assess impacts on the current account, income distribution and the environment before finalising the mix.
9. Illustrative real‑world examples
9.1 United Kingdom – early 1990s
After persistent inflation in the 1970s‑80s, the Bank of England raised interest rates sharply. The contractionary monetary stance reduced inflation but pushed unemployment above the natural rate. Subsequent supply‑side reforms (privatisation, deregulation, investment in skills) shifted LRAS right, allowing unemployment to fall without reigniting inflation.
9.2 United States – 1970s stagflation
Both unemployment and inflation were high, a situation explained by cost‑push inflation from oil shocks and a left‑shifting SRAS. Pure demand‑side policies failed; only a combination of tight monetary policy (to curb inflation) and later supply‑side measures (deregulation, tax reform) restored stability.
9.3 Eurozone – post‑2008 crisis
Fiscal consolidation in several countries reduced deficits but initially raised unemployment. Simultaneously, the European Central Bank pursued low‑interest rates and QE to support demand, while structural reforms (labour‑market flexibility, innovation incentives) were introduced to improve LRAS. The mixed approach illustrates the need to balance the two core aims.
10. Key take‑aways for the exam
- The short‑run trade‑off between full employment and stable prices is illustrated by the downward‑sloping Phillips curve and the AD–AS model.
- Demand‑pull inflation arises when AD rises faster than SRAS; cost‑push inflation can occur even with high unemployment.
- Pure demand‑side policies cannot remove the conflict; long‑run supply‑side reforms are essential for sustainable improvement.
- Credible expectations (inflation targeting, clear communication) reduce the size of the trade‑off.
- Effective macro‑policy must consider all six Cambridge aims; progress on one often influences the others.
11. Suggested diagrams (to be drawn by the student)
- AD–AS diagram showing an expansionary fiscal shift of AD from point A (high unemployment, low inflation) to point B (lower unemployment, higher inflation).
- Short‑run Phillips curve with a movement from point P₁ (u > u*, low π) to point P₂ (u < u*, higher π).
- Long‑run LRAS shift right after supply‑side reforms, illustrating how the same AD level can now deliver lower unemployment without raising the price level.
- Combined AD–AS & Phillips‑curve diagram that links a right‑hand AD shift to a movement along the short‑run Phillips curve.