Conflicts Between Macroeconomic Objectives

Governments typically pursue four key macroeconomic objectives: sustained economic growth, low unemployment, low and stable inflation, and a satisfactory balance of payments position. However, pursuing one objective often makes it harder to achieve another. Understanding these trade-offs and conflicts is central to macroeconomic analysis and policy evaluation at A-Level.

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The Four Main Macroeconomic Objectives

Objective	UK Target/Benchmark	Responsible Body
Economic growth	Sustained real GDP growth (trend rate ~2–2.5% p.a.)	Government (fiscal policy); Bank of England (monetary policy)
Low unemployment	Unemployment at or near the natural rate (~4–5%)	Government (supply-side policies); Bank of England
Low and stable inflation	CPI = 2% ± 1 percentage point	Bank of England Monetary Policy Committee (MPC)
Satisfactory balance of payments	Sustainable current account (no specific target)	Government (trade policy); market forces

Additional objectives sometimes included: equitable distribution of income, environmental sustainability, balanced government budget.

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The Phillips Curve

The Original Phillips Curve (1958)

Key Definition: The Phillips curve (A. W. Phillips 1958) is an empirical relationship showing an inverse correlation between the rate of unemployment and the rate of change of money wages (later adapted to show the trade-off between unemployment and inflation).

Phillips examined UK data from 1861 to 1957 and found that when unemployment was low, wage inflation was high, and vice versa. This suggested a stable, predictable trade-off: policymakers could choose a point on the curve, accepting higher inflation in exchange for lower unemployment, or vice versa.

Why might such a trade-off exist?

• When unemployment is low, the labour market is tight → firms must offer higher wages to attract and retain workers → higher wages increase costs → firms raise prices → inflation rises.
• When unemployment is high, there is excess labour supply → workers have less bargaining power → wage growth is restrained → inflation falls.

Paul Samuelson and Robert Solow (1960) adapted the Phillips curve for the US economy and popularised it as a policy menu — suggesting that governments could "trade off" between inflation and unemployment.

Exam Tip: Phillips found a relationship between unemployment and wage inflation. Samuelson and Solow reinterpreted it as a relationship between unemployment and price inflation. This distinction matters for the most precise answers.

The Expectations-Augmented Phillips Curve (Friedman 1968, Phelps 1967)

Milton Friedman (1968) and Edmund Phelps (1967), working independently, challenged the idea of a stable long-run trade-off. They introduced the concept of the expectations-augmented Phillips curve:

Key argument: In the short run, there may be a trade-off between inflation and unemployment. But in the long run, the economy returns to the natural rate of unemployment regardless of the inflation rate. There is no long-run trade-off.

The mechanism (adaptive expectations):

1. The government expands aggregate demand to reduce unemployment below the natural rate.
2. Initially, this succeeds: output and employment rise, and inflation increases (movement along the short-run Phillips curve, SRPC₁).
3. However, workers gradually realise that inflation has risen. They revise their expectations upward and demand higher nominal wages to restore their real wages.
4. Higher wages increase costs → firms reduce employment → unemployment returns to the natural rate, but at a higher rate of inflation.
5. The short-run Phillips curve has shifted upward (to SRPC₂). If the government tries again, the process repeats at an even higher inflation rate.
6. The long-run Phillips curve (LRPC) is therefore vertical at the natural rate of unemployment.

Key Definition: The NAIRU (Non-Accelerating Inflation Rate of Unemployment) is the rate of unemployment at which inflation is stable. It corresponds to the natural rate and is the point at which the long-run Phillips curve is vertical.

Policy implication (Friedman): Demand-side policies cannot permanently reduce unemployment below the natural rate. Any attempt to do so will only generate accelerating inflation. The only way to reduce the natural rate is through supply-side policies that improve the functioning of the labour market.

The Lucas Critique and Rational Expectations

Robert Lucas (1976) went further, arguing that economic agents form rational expectations based on all available information, not just past experience. This implies that:

• If the government announces an expansionary policy, workers will immediately anticipate the resulting inflation and demand higher wages.
• There is no trade-off, even in the short run, if the policy is anticipated.
• Only unexpected policy changes can temporarily reduce unemployment below the natural rate.

This is the New Classical position. It suggests that systematic, predictable demand management policies are completely ineffective at influencing real variables like output and employment (the policy ineffectiveness proposition).

Exam Tip: In a Phillips curve essay, you should present: (1) the original Phillips curve (stable trade-off), (2) Friedman's critique (no long-run trade-off), and (3) Lucas's critique (no trade-off even in the short run if policy is anticipated). Then evaluate which view is most consistent with the evidence.

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Key Macroeconomic Conflicts

1. Inflation vs Unemployment

The Phillips curve debate is the classic expression of this conflict. In the short run, reducing unemployment (by stimulating AD) tends to increase inflation; reducing inflation (by contracting AD) tends to increase unemployment.

UK example: The Bank of England's rate rises from 2022 to 2023 were designed to reduce inflation from 11.1% but were expected to increase unemployment by approximately 1 percentage point.

2. Economic Growth vs Inflation