conflicts-between-the-macroeconomic-objectives

How Output Gaps Relate to Unemployment & Inflation

• Understanding the relationship between output gaps, unemployment, and inflation is crucial for policymakers

  • Reducing a negative output gap by stimulating demand may lead to lower unemployment but could also contribute to inflation

  • Conversely, efforts to cool down an overheating economy with a positive output gap might reduce inflation but could result in higher unemployment

Relationship Between Output gaps & Unemployment / Inflationary Pressures

The Short Run Phillips Curve

• The Short-run Phillips Curve (SRPC) observes that there may be a trade-off between unemployment and inflation

  • Rising inflation is often accompanied by falling unemployment

  • Rising unemployment is often accompanied by falling inflation

  • This trade-off makes it difficult for the government to achieve both low unemployment and low inflation

Diagram: The Short-run Phillips Curve

Diagram analysis

• The economy is initially in equilibrium at AP₁Y_FE

• At this point, unemployment is at 4% and inflation is at 3% and this is considered to be full employment (Y_FE)

  • There is always some unemployment due to the frictional and structural unemployment that exists

• An increase in AD from AD₁→AD₂ causes a positive output gap (Y_FE – Y₂)

  • With an increase in output the demand for labour rises and unemployment falls from 4% → 3%

  • The remaining labour in the market is scarcer and workers are able to negotiate higher wages

    • This causes wage inflation in the economy

  • Wage inflation leads to an increase in inflation from 3% → 4%

• A decrease in AD from AD₁ → AD₃ causes a negative output gap (Y_FE – Y₃)

  • With a decrease in output, the demand for labour falls and unemployment rises from 4% → 5%

  • Labour is more abundant, and to get hired workers have to accept lower wages

    • This causes wage deflation in the economy

  • Wage deflation leads to a decrease in inflation from 3% → 2%

The Long Run Phillips Curve

• The long-run Phillips curve (LRPC) suggests there is no trade-off between inflation and unemployment in the long run
   

• The curve is based on the idea of a natural rate of unemployment (NRU)

  • This is the unemployment rate that prevails when the economy is operating at its full potential

  • It represents the level of unemployment consistent with non-accelerating inflation, meaning that further reductions in the unemployment rate cannot be achieved without generating inflationary pressures 

• The LRPC is vertical at the natural rate of unemployment

  • In the long-run, the short-run Phillips curve moves around the vertical long run curve as the labour market self corrects in the long run

  • In the long-run wages and prices are flexible

Diagram: SRPC Self Correction to LRPC

Diagram analysis

• The NRU of 4.5% represents the LRPC

• in the short-run, AD has increased causing a leftward movement along the SRPC from point A → B (higher inflation and lower unemployment)

• In the long-run, the economy will move from point B to C as following the increase in AD, workers see their real wages fall and so eventually demand higher wages

  • In response, firms reduce employment and raise prices, returning unemployment to its natural rate (NRU), now at a higher inflation rate

• If there has been deflation in the economy, workers will accept lower wages in the long-run and employment and output will return to the full-employment level

The Implications of the Phillips Curve for Economic Policy

The implications for short-run policy decisions

• Governments have to accept trade-offs in the macroeconomic objectives

• Achieving one objective may come at the cost of worsening progress in another objective

  • Increasing economic growth causes the economy to move closer to full employment

  • However, prices for remaining resources are bid up leading to inflation which may outpace the target inflation rate of 2%

An Explanation of the Common Trade-offs that Exist Between the Macroeconomic Objectives

The implications for long-run policy decisions

• LRPC suggests that there is no permanent trade-off between inflation and unemployment over an extended period

• In the long run, the economy tends to return to its natural or potential level of output

  • Policymakers should not use demand side policies (monetary/fiscal) to permanently reduce unemployment below its natural rate.

    • Attempts to do so may lead to higher inflation without sustaining lower unemployment

  • Instead, policymakers should consider supply-side policies, such as education and training programs, labour market reforms, and measures that enhance productivity and efficiency