What this lesson teaches
I can explain how macroeconomic aims can conflict and how that shapes policy choices.
Syllabus 9570, 3.2.3(c). Macroeconomic Policies: Possibilities of conflicts between macroeconomic objectives and how this may affect governments' decision on macroeconomic policy
Make a guess
Oil prices jump, so prices rise and output falls. The government boosts spending to restore output. What happens to inflation?
- It stays the same, because the shocks cancel out.
- It gets worse, as higher demand pushes prices up further.
- It falls, because more output means more goods to go round.
Show the answer
It gets worse, as higher demand pushes prices up further.
Stagflation creates a trade-off. Raising AD restores output but adds demand-pull pressure to the cost-push inflation.
Policies that help one objective can hurt another, so governments must choose priorities.
Governments want growth, low unemployment, stable prices and a sustainable balance of payments, but these can conflict.
Raising AD boosts growth and jobs, but adds to inflation near full capacity.
Cutting AD to fight inflation slows growth and raises unemployment.
A cost-push shock creates the hardest choice: prices rise and output falls together (stagflation). Supporting output with more demand raises prices further. For Singapore, a stronger S$ fights inflation but hurts export competitiveness.
- Growth vs inflation
- Raising AD adds to inflation near capacity.
- Stagflation
- Demand tools cannot fix both output and prices.
Worked example: Restoring output at a higher price
Suppose a cost shock moves an economy from output 100 and prices 100 to output 86.7 and prices 113.3. A demand boost would restore output to 100, but raise prices to 120.
- The shock alone causes stagflation.
- The demand boost fixes output but makes inflation worse.
- Better options target the cost shock: easing supply constraints, or appreciation to cut import prices.
- Targeted help can protect vulnerable groups without a broad rise in AD.
Watch out for this
A government can always achieve all its objectives at once.
Some objectives conflict in the short run, so trade-offs have to be made.
Check your understanding
Why is stagflation hard for demand management to fix?
- Raising AD helps output but worsens inflation; cutting AD does the reverse.
- Fiscal policy stops working during stagflation, because firms ignore the Budget.
- Stagflation is caused by too much demand, so cutting AD cures both problems.
Show the answer
Raising AD helps output but worsens inflation; cutting AD does the reverse.
Right. Demand tools move output and prices in the same direction.