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Conflicts between macroeconomic goals occur because governments cannot pursue all goals at once. There is a trade-off between these goals. Choosing one goal requires the government to forego or not achieve other goals. Thus, the government must decide which macroeconomic goals are the most important.
Before further examples of conflicts between macroeconomic goals, let’s break down these five goals. They are:
- High and sustainable economic growth
- Price stability
- Full employment
- Balance of payments equilibrium
- Fair distribution of income
High and sustainable economic growth. A growing economy creates more jobs and income for households. That is usually an important goal for the government.
Price stability. Some countries are targeting an inflation rate of 2%, which is considered a healthy level. Lower or higher percentages usually encourage the government to intervene.
Full employment. This does not mean a zero percent unemployment rate. Rather, those willing and actively looking for work have found it. When the economy reaches full employment, structural and frictional unemployment persists. That is the reason why the unemployment rate will not equal zero percent.
Balance of payments equilibrium. This occurs when what the economy spends and invests abroad is nothing more than foreign spending and investment into the domestic economy. In other words, payments abroad are the same as payments received by an economy.
Fair distribution of income. It is about how income is distributed among citizens, and the sharp gap between rich and poor is minimized.
Economic growth vs. Price stability
Higher economic growth results in higher inflation rate. It could work through aggregate demand.
Say the central bank lowers interest rates to stimulate economic growth. Borrowing costs become cheaper, encouraging households to increase consumption and businesses to invest. As a result, aggregate demand rises.
Since the interest rate is not explained in the aggregate demand model, its decrease will shift the aggregate demand curve to the right. As a result, aggregate demand increases, causing aggregate output to rise, but that will be accompanied by an increase in aggregate prices (inflation rises).
When aggregate demand continues to rise, it can lead the economy to operate above its full capacity – in the graph, it occurs when the aggregate demand curve intersects with the short-run aggregate supply curve just to the right of the long-run aggregate supply curve (potential GDP). Inflation continues to rise, and if not addressed (for example, by raising interest rates), it could harm the economy. Inflation can spike through a wage-price spiral effect.
What is the wage-price spiral? It is a continuous rise in inflation due to rising wages. During inflation, real wages decline because the prices of goods and services increase faster than nominal wages increase. Eventually, workers will negotiate higher wages.
Higher wages increase production costs. Faced with this situation, businesses will increase their selling prices to compensate for the increased costs and maintain their profit margins.
Rising selling prices pushed inflation higher, prompting workers to renegotiate higher wages. An increase in wages will push inflation up much higher, and so on. Finally, it creates a wage-price spiral, in which rising inflation will lead to higher wages and eventually push the inflation rate towards higher levels.
Such a spiral could harm the economy. Therefore, the central bank will intervene by raising interest rates. An increase in interest rates weakens aggregate demand, causing the curve to shift to the left. Aggregate output decreases (lower economic growth), but the price level also falls.
Full employment vs. Price stability
When the unemployment rate is at its natural level, it cannot fall again without raising the inflation rate. Thus, pursuing lower unemployment will sacrifice price stability.
During full employment, people who are willing and actively looking for work have found it. The labor market is tight, and companies find it difficult to attract skilled workers.
A further decline in unemployment will cause the labor market to become tighter and push wages up. As a result, companies must pay more to recruit new workers. They will pass wage increases on to selling prices to maintain profit margins. So, recruiting workers—lowering unemployment—will only cause inflation to rise.
This trade-off can also work from the demand side. When inflation is high, the central bank raises interest rates to avoid overheating the economy. As a result, borrowing costs become more expensive. That ultimately weakens household consumption and business investment, leading to lower aggregate demand.
A decrease in aggregate demand will encourage businesses to reduce their output and take steps to save operating costs, such as reducing workers. As a result, the unemployment rate will increase while the inflation rate will decrease due to weaker demand.
Economic growth vs. Balance of payments equilibrium
Encouraging higher economic growth will result in a balance of payments disequilibrium. For example, during economic growth, households are more prosperous. They see their job and income prospects improving. Finally, they spend more on goods and services, causing aggregate demand to rise.
An increase in aggregate demand raises the price level, prompting businesses to increase their output. Further demand increases could lead the economy to operate above its potential output. However, not all aggregate demand can be met by domestic production, which ultimately increases imports.
On the other hand, increased aggregate demand also pushed up inflation. This results in less competitive domestic goods because they are relatively more expensive for foreigners. As a result, exports tend to decline.
Increased imports and decreased exports eventually resulted in disequilibrium in the balance of payments. As a result, a trade deficit occurs, and payments to foreign countries (due to imports) are greater than payments received (from exports).
Full employment vs. Balance of payments equilibrium
Full employment occurs when the unemployment rate is at its natural rate. And the real output is equal to the potential output. And the economy operates at full capacity.
Full employment is the lowest point in the unemployment rate. In other words, during this period, the economy was prosperous. However, a further decline in the unemployment rate will result in a balance of payments disequilibrium.
If the unemployment rate falls further, wages will rise as the labor market tightens. An increase in wages will push inflation up because businesses will pass the increase in production costs (due to an increase in wages) to the selling price. As a result, domestic products are less competitive in foreign markets, reducing foreigners’ demand (exports decline).
Meanwhile, as the economy prospers, aggregate demand tends to rise. As a result, the economy could operate above its potential output. And because it exceeds its full capacity, imports will increase.
Finally, an increase in imports and a decrease in exports results in a balance of payments disequilibrium.
