2.6.3 Potential policy conflicts and trade-offs

What is the short-run trade-off between unemployment and inflation?

As economic growth increases, unemployment falls, wages rise, consumer spending increases, which can increase inflation (Phillips curve).

How can supply-side policies affect the unemployment-inflation trade-off?

They reduce structural unemployment without increasing average wages, limiting inflation.

Why does economic growth create inflationary pressures?

Positive output gap and AD growing faster than AS increases the average price level.

What is a negative output gap?

Actual output < potential output; spare capacity exists; downward pressure on inflation.

What is a positive output gap?

Actual output > potential output; resources overused; upward pressure on inflation.

How does economic growth affect the current account?

Higher consumer spending, high propensity to import → worsens current account deficit.

How can a country achieve export-led growth?

Focus on exports (like China/Germany) to have growth and a current account surplus simultaneously.

How does reducing a government budget deficit affect economic growth?

Less spending and higher taxes reduce AD → lower growth.

Why does high economic growth impact the environment?

More manufacturing → more pollution and non-renewable resource use.

How can environmental policies conflict with competitiveness?

Green taxes or pollution limits can increase production costs, reducing firm competitiveness.

How can progressive taxes conflict with inflation?

Higher taxes like VAT can increase prices for firms and consumers → inflation rises.

How can expansionary fiscal policy conflict with monetary policy?

More borrowing raises interest rates and inflation, countering monetary policy goals.

How can low interest rates affect income inequality?

Savers earn less on savings → income distribution affected.

Why are some policies politically difficult?

Reducing deficit requires spending cuts and tax rises → unpopular.

Why do supply-side policies have delayed effects?

Education/training take years to improve productivity; tax changes have quicker effects.

How can external events limit policy effectiveness?

Financial crises or global interest rates affect domestic economy beyond government control.

What is a free market economy?

Laissez-faire system; private individuals and firms make all decisions; minimal government intervention.

What are the advantages of a free market economy?

Efficiency, lower costs, higher output, less bureaucracy, more personal freedom.

What are the disadvantages of a free market economy?

Inequality, monopolies, underprovision of public/merit goods, overconsumption of demerit goods.

What is a command economy?

Government allocates all resources; central planning; government decides what/how/for whom to produce.

What are the advantages of a command economy?

Easier coordination in crises, reduce inequality, prevent monopoly abuse, meet basic needs.

What are the disadvantages of a command economy?

Governments may fail, misallocate resources, limit consumer choice and personal freedom.

What is a mixed economy?

Features of both free and command economies; government and market allocate resources together.

How does a mixed economy determine what/how/for whom to produce?

What: consumers & government; How: producers seek profit & government regulation; For whom: government preference & purchasing power.

What are unintended consequences of government policies?

Consumers/producers react unexpectedly, undermining policy goals.

Give an example of unintended consequences.

Raising minimum wage → higher costs for employers → possible job losses.