2.6.4 conflicts and trade-offs between objectives and policies

What is a common trade-off between economic growth and the environment?

Economic growth generally involves increased use of natural resources and production of goods, which results in higher levels of pollution, noise, and destruction of natural habitats. Although it is possible to achieve economic growth without environmental harm through sustainable development strategies, such growth is typically slower and more costly due to the investment and regulatory requirements needed to protect natural ecosystems.

How can economic growth affect a country’s balance of payments?

(Growth can worsen the balance if it raises demand for imports (e.g., India), or improve it if growth is export-led (e.g., China).) Economic growth can lead to balance of payments problems if rising incomes cause increased demand for imports, as seen in countries like India where industrial output mainly serves domestic markets. Conversely, growth that is driven by export-oriented industries, such as in China, can improve the balance of payments by generating trade surpluses through large-scale production of goods for foreign markets.

What did A.W. Phillips discover about unemployment and inflation?

(The Phillips Curve shows a short-run inverse relationship: lower unemployment leads to higher inflation, and vice versa.) A.W. Phillips empirically identified a short-run inverse relationship between unemployment and inflation, formalized as the Phillips Curve. He observed that when unemployment is low, wage inflation tends to rise because firms compete for scarce labor by offering higher wages, which are subsequently passed on as higher prices, leading to inflation. Conversely, when unemployment is high, wage growth slows and inflation remains subdued.

What is stagflation and when was it observed?

(Stagflation is high unemployment combined with low inflation, observed in the 1970s, contradicting the Phillips Curve.)Stagflation is an economic condition characterized by the unusual combination of high unemployment and high inflation occurring simultaneously, which contradicts the traditional Phillips Curve trade-off. It was prominently observed in the 1970s, notably during the oil crises, when economies experienced stagnant growth alongside rising prices.

What conflict arises between expansionary and deflationary fiscal or monetary policies?

(Expansionary policies boost growth and employment but increase inflation and may worsen the balance of payments; deflationary policies reduce inflation but lower growth and increase unemployment.)Expansionary fiscal and monetary policies, which aim to increase aggregate demand (AD), typically boost output, employment, and economic growth, but they also risk increasing inflation and worsening the balance of payments due to higher imports. Deflationary policies reduce AD to control inflation, but this often results in decreased employment and slower economic growth, creating a trade-off for policymakers.

How can raising interest rates create conflicts between economic objectives?

(Higher rates reduce inflation but hurt long-term investment and growth, raise currency value (hurting exports), and can increase wealth inequality.)Increasing interest rates is an effective tool to reduce inflation by curbing borrowing and spending. However, persistently high rates can damage long-term business investment, thereby undermining future economic growth. Additionally, higher interest rates tend to appreciate the domestic currency, which can decrease exports and increase imports, worsening the balance of payments. Furthermore, interest rate hikes disproportionately benefit savers and lenders, who are often older and wealthier, thereby potentially exacerbating income and wealth inequality.

What are the social impacts of supply-side policies?

(While supply-side policies improve long-term growth and reduce inflation, they may increase income inequality and harm the environment or government budgets.) Supply-side policies aim to increase aggregate supply, enhancing long-term economic growth and reducing inflationary pressures. However, some policies—such as reducing trade union power, lowering wages, cutting benefits, and adjusting taxation—may disproportionately affect lower-income groups, thereby increasing income inequality. Additionally, certain supply-side measures may have adverse effects on government budgets and the environment.

Why can reducing fiscal deficits through spending cuts and tax hikes conflict with other objectives?

(These measures reduce AD, lowering growth and increasing unemployment, often hitting poorer groups hardest and reducing tax revenues.) To reduce fiscal deficits, governments often cut spending and raise taxes, which lowers aggregate demand and thus short-term economic growth, while also increasing unemployment. These contractionary effects disproportionately affect poorer populations who rely more on government services. Moreover, as output falls, tax revenues decrease, which can undermine the effectiveness of deficit reduction efforts.

Define the Short-Run Phillips Curve (SRPC).

(It is a downward-sloping curve showing a trade-off between inflation and unemployment in the short term.) The SRPC is a downward-sloping curve representing an empirical inverse relationship between inflation and unemployment in the short run, indicating that policies reducing unemployment tend to increase inflation, and vice versa, due to wage-price dynamics.

What does NAIRU stand for and signify?

(Non-Accelerating Inflation Rate of Unemployment—the unemployment level at which inflation remains stable.) NAIRU stands for the Non-Accelerating Inflation Rate of Unemployment, which is the specific unemployment rate at which inflation remains stable and does not accelerate. If unemployment falls below this level, inflation tends to rise, and if it rises above, inflation tends to fall.

Give an example of a real-world trade-off between economic growth and the environment.

(Rapid growth in China caused serious pollution and environmental damage.) Rapid economic growth in China has been accompanied by serious environmental degradation, including air and water pollution, habitat loss, and increased noise pollution, illustrating the classic trade-off between expanding output and protecting ecological systems.

How does unemployment influence wage inflation according to the Phillips Curve?

(Low unemployment causes firms to offer higher wages to attract workers, increasing inflation.) According to the Phillips Curve, when unemployment is low, firms compete to attract the limited available workers, leading to upward pressure on wages. These wage increases are then typically passed on to consumers in the form of higher prices, contributing to inflation.

What is the effect of high interest rates on wealth distribution?

(They benefit savers (often older people) and can increase income inequality.) High interest rates tend to benefit savers and lenders who receive higher returns on their savings and loans, groups that are often older and wealthier. Meanwhile, those without savings, such as younger or lower-income individuals, may face higher borrowing costs, thereby exacerbating wealth and income inequalities.

Why might supply-side policies increase short-term inflation despite reducing it in the long run?

(They can boost investment and aggregate demand initially.) Supply-side policies can stimulate investment and aggregate demand in the short term by encouraging businesses to expand productive capacity. This initial boost to demand can temporarily increase inflationary pressures before longer-term improvements in supply reduce inflation.

What trade-off exists between reducing unemployment and maintaining a balanced budget?

(Increasing employment often requires government spending, leading to budget deficits.) Reducing unemployment often requires increased government spending on welfare and job creation programs, which can lead to budget deficits. Attempts to reduce these deficits by cutting spending or raising taxes may, in turn, increase unemployment or reduce economic growth.

How does India’s economic growth affect its balance of payments differently from China’s?

India’s growth is driven largely by domestic production for its own population, leading to increased demand for imported goods and causing balance of payments problems. China’s growth is export-led, resulting in a balance of payments surplus

How do interest rates affect income inequality through different types of wealth?

High interest rates benefit savers, usually older people with bank savings, while the richest hold more non-money assets like stocks and shares, which are less affected by interest rates, potentially increasing income inequality.

Why might reducing fiscal deficits through spending cuts and tax rises be less effective than expected?

As output falls due to reduced AD, tax revenues also decline, undermining the intended deficit reduction and making the policy less effective.

What specific supply-side policy tools can increase income inequality?

Policies that reduce trade union power, lower wages, cut benefits, and change taxation can negatively affect the poorest groups, increasing income inequality.

What are the potential adverse side effects of some supply-side policies besides inequality?

Some supply-side policies can negatively impact the government budget and harm the environment.

What are the key macroeconomic objectives governments aim for?

Economic growth, low unemployment, price stability (low inflation), and a balanced balance of payments.

Describe the axes and slope of the Short-Run Phillips Curve diagram.

The vertical axis represents the inflation rate, the horizontal axis represents the unemployment rate, and the curve slopes downward, showing an inverse relationship between inflation and unemployment in the short run.