Macro-economic policy conflicts

Macro-economic policy objectives often conflict with each other. This means that, in attempting to achieve one objective - such as promoting growth - other objectives - such as achieving keeping a balance of payments - may be sacrificed.

Conflicts arise because changes in a single economic variable affect several other economic variables. For example, an increase in the rate of personal income tax will directly affect a whole range of variables, including disposable income, consumer spending, savings as well as other indirect effects, such as on business confidence, investment and imports.

Trade offs

Policy conflicts are common and often force policy-makers to accept the need for trade-offs. If X and Y are in conflict, then a little less of X means a little more of Y. Policy-makers will decide exactly how much less (or more) of X is acceptable in order to achieve a little more (or less) Y.

Policy conflict
Full employment and stable prices

Maintaining a stable price level is an important macro-economic objective as is the desire to achieve full employment equilibrium. If an economy is experiencing an unacceptable level of unemployment it will look to reduce it. However, there is a clear possibility that the price level will rise, perhaps even in an accelerating fashion.

If aggregate demand is stimulated by an increase in government spending, the demand for labour will increase, which puts upward pressure on wages, and then on to costs, which may result in an increase in prices. Jobs are created, but at the cost of inflation. The nearer the economy gets to full employment the more likely it is that extra demand simply pulls up prices rather than creating more jobs.

Much depends on whether an economy is at its non-accelerating-inflation rate of unemployment (NAIRU) - that is, the rate of unemployment which is associated with the economy's long run 'natural' output. Achieving NAIRU is an important policy objective in that achieving it is unlikely to result in a significant inflation trade-off.

This conflict is clarified by considering the Phillips Curve.

Inflation and unemployment and the Phillips curve

Here, PC is the short-run Phillips curve, and LRPC is the Long Run Phillips curve which is at NAITU, at 6% unemployment. Any attempt to reduce actual unemployment below NAIRU will result in a higher inflation rate. Hence reducing unemployment from 6% to 3% results in the inflation rate moving from 0% to 6%.

 

More on inflation
Policy conflict
Economic growth and the balance of payments

As an economy grows the quantity of goods imported and the value of imports is likely to increase. In simple terms, imports M are a function of national income Y (M=fY). This means that a given increase in national income will result in a given increase in domestic imports. However, exports are determined by overseas income - along with a number of other factors - hence, in a simple model of trade, an increase in national income will worsen the trade balance. This can be seen in the following 'cross' diagram.

Conflicts of objectives - growth and trade

In this case, growth from Y to Y1 causes an increase in imports, which rise from a to b. This opens up a trade gap, the extent of which depends upon the marginal propensity to import (MPM). Graphically, the steeper the import line, the greater the gap created as a result of economic growth. Less import dependency will partly reduce the severity of the policy conflict, as will ensuring that economic growth is as close to its long-term trend rate as possible.

Of course, if there is a surplus on trade already, economic growth will reduce the surplus, and move the trade balance towards equilibrium.

More on trade
Policy conflict
Economic growth and the environment

As economies grow, production and consumption will also increase. This means that the environment may suffer.

For example, negative externalities associated with road and air transport, the increased use of fossil fuels, and more waste all impact the environment.

In addition, certain resources may be non-renewable, and rapid growth today can leave future generations will fewer available resources. It can also be argued that the exhaustion of some non-renewables, such as fossil fuels, will encourage the search for less harmful alternatives, such as use of wind and solar power, and efficient car batteries to power electric vehicles.

The 'environmental Kuznets Curve' suggests that environmental degradation will accelerate with economic growth, but that this slows down beyond a certain point and then declines as economies find solutions to environmental harms, including effective policy interventions.

Conflicts of objectives - growth and the environment

Environmental degradation may slow down as economies become more affluent and attitudes change with consumers more willing to accept paying a higher price for goods from sustainable resources, or using less polluting technology. Rising national income also enables more funds to flow into research and new technologies.

Critics argue that there is nothing inevitable about the expected decline in environmental degradation, and that specific harms related to global warming are a global phenomenon that individual economies cannot deal with in isolation.

More on externalities
Policy conflict
Growth and inflation

As economies grow, the demand for scarce resources also grows, which can put pressure on the prices of resources. This transmits through to producer prices and then on to consumer prices.

Policies which promote growth, including fiscal and monetary expansion, also put pressure on the price level.

Graphically, a fiscal expansion can be shown with a shift of the aggregate demand curve to the right. How significant the trade-off is depends on how close the economy is to operating at full capacity.

In the following diagram we can see that a fiscal stimulus would not be inflationary if the economy moved from Y to Y1 as it occurs in the elastic portion of the aggregate supply curve, but would be highly inflationary if moving from Y2 to Y3 as the economy approaches full employment, and supply become perfectly inelastic.

Conflicts of objectives - growth and inflation
More on growth

Other conflicts

Other policy objectives can also be in conflict, including economic growth and inequality - which is explained by looking at the Kuznets curve.

The desire to control public finances may also conflict with economic growth, employment and the reduction of inequality. The austerity measures imposed by many governments after the financial crash in 2007-08 resulted from an attempt to reduce the level of government borrowing. The crash revealed that many governments had large 'structural' deficits (deficits which did not close at any point in the business cycle) and control of public finances became a dominant policy objective. The downside of this was rising inequality and increasing poverty levels.

Conclusion

Finally, the extent of any conflict is partly determined by which policy instrument is chosen.

Short-term demand management policies are more likely to cause conflicts that longer term supply-side policy.

Given that supply-side policy takes time to work (which may seem a disadvantage) it allows output and employment to increase at a slower rate - which means that necessary adjustments are more likely to take place.

For example, while spending on education and training is expensive and takes a long time to yield any positive results, it can have a significant impact on productivity, skills and innovation. This means that the economy is more able to respond to increases in aggregate demand without causing any inflationary trade-off.


Aggregate demand

Aggregate demand and the AD curve.

Aggregate demand
Fiscal policy

How can fiscal policy influence aggregate demand?

Fiscal policy
Monetary policy

How effective is supply-side policy?

Supply-side policy