Chapter 46 — Links Between Macroeconomic Problems and Their Interrelatedness

Cambridge International AS & A Level Economics (9708) · Unit 10.2 · 4th edition coursebook

46.1The relationship between the internal and external value of money

The internal value of a country's currency is the purchasing power of one unit of that currency in the domestic market — what a dollar, a pound or a peso buys at home. The external value is the rate at which it exchanges for other currencies. The two values are linked. Inflation reduces internal value: each unit of the currency buys less than before.

If a country's inflation rate rises above that of its rival countries, foreigners demand fewer of its now-more-expensive exports, so demand for the currency on the foreign exchange market falls. At the same time, domestic households and firms switch to relatively cheaper imports, so the supply of the currency on the foreign exchange market rises. Lower demand and higher supply combine to depreciate the currency (see Figure 46.3).

The link runs in the other direction too. A fall in the exchange rate raises the home-currency price of imports. Each unit of the currency now buys fewer of the now more expensive imported goods, so the internal value falls. The example often used is a bilateral exchange rate moving from US$1 = 8 Argentine pesos to US$1 = 6 Argentine pesos: an Argentine import priced at 480 pesos rises from US$60 to US$80 once converted. Purchasing power is also eroded indirectly. The rise in the price of imported raw materials pushes up domestic costs, and the reduction in competitive pressure from imports allows domestic firms to lift their own prices. So internal and external values of a country's money tend to move directly together: a fall in the internal value leads to a fall in the external value and vice versa.

This relationship is the most common case but it is not automatic. A country may experience domestic inflation yet still see its external value rise — for example, if it operates a fixed exchange rate, or if its inflation rate is still below that of its rival trading partners.

46.2The relationship between the balance of payments and inflation

If a country's inflation rate rises above that of its main competitors, its price competitiveness falls. Export revenue declines, import expenditure rises, and the current account balance deteriorates. The causation also runs the other way: an increase in the current account surplus can itself cause inflation, because net exports are making an increasing contribution to aggregate demand and more money is flowing into the country than is leaving it.

That upward pressure on the domestic price level — and the matching downward pressure on the internal value of the currency — may be short-lived. An increasing current account surplus tends to cause an appreciation of the exchange rate. The stronger currency in turn reduces the surplus and lowers the inflation rate, because the price of imported products falls and domestic firms come under more pressure to keep their own prices low.

The financial account can also affect inflation. A net inflow on the financial account — for example, foreign direct investment by multinational companies — may reduce inflation if those firms bring in advanced technology and add to competitive pressure inside the economy.

46.3The relationship between growth and inflation

A high rate of inflation is likely to reduce a country's economic growth rate. Higher domestic prices erode price competitiveness, so net exports fall, lowering aggregate demand. Reduced aggregate demand reduces output — or at least slows the growth of output.

The effect running the other way is less clear-cut. Actual economic growth may be accompanied by either cost-push or demand-pull inflation. As more is produced, firms compete more aggressively for resources, including labour, so input prices and wages rise. The extra output also generates extra income, which feeds back into aggregate demand. The gap between rising aggregate demand and the economy's ability to expand output gets more acute as the economy approaches full employment, so the inflationary pressure intensifies.

Potential economic growth — growth in productive capacity — can reduce inflation rather than add to it. It allows aggregate demand to expand without pushing the price level up, and it can directly reduce unit costs of production. Advances in technology, for example, let a higher output be produced per factor input, lowering the cost of each unit.

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46.4The relationship between growth and the balance of payments

Economic growth can be export-led: a rise in net exports raises GDP by a multiple amount through the multiplier effect, and the same change improves the current account. Potential economic growth can produce a similar positive relationship, because expanding capacity tends to raise the price competitiveness — and, depending on what is being expanded, the quality competitiveness — of the country's products.

The relationship can also be inverse, at least in the short run. To produce a higher output, firms may import more raw materials and capital goods. If part of the resulting extra output is then exported, the initial rise in imports may eventually be matched by a rise in exports, but the timing of the two flows is not the same.

Causation can run from the balance of payments to growth as well as the other way around. An increase in a current account surplus raises aggregate demand, which can stimulate actual economic growth.

46.5The relationship between inflation and unemployment

The relationship between inflation and unemployment has been one of the most heavily studied questions in macroeconomics. Economists have looked at how changes in inflation can affect unemployment, how changes in unemployment can affect inflation, and how government policies aimed at reducing unemployment end up influencing both variables together.

The Phillips curve

The most famous study was published in 1958 by Bill Phillips, a New Zealand economist based at the London School of Economics. He analysed historical data on unemployment and money wages — used as an indicator of inflation — in the UK over the period 1861 to 1957, and found an inverse relationship between the two. The Phillips curve that summarised his finding slopes downward from left to right (see Figure 46.5).

The curve is not a straight line. It is steeper at low rates of unemployment, indicating that pushing unemployment from a very low rate to an even lower rate causes a sharp rise in inflation. As unemployment increases, the curve becomes much flatter, so further reductions in unemployment from a high base do less to raise inflation, and at very high rates of unemployment the economy may even experience deflation. The economic logic is that a fall in unemployment raises aggregate demand and puts upward pressure on wages, so the price level rises with it.

The traditional Phillips curve also implied that a government could choose its preferred combination of unemployment and inflation by moving along the curve. Faced with, for example, 8% unemployment and 4% inflation, a government could use expansionary fiscal or monetary policy to lower unemployment to 5%, accepting that the gain in employment would be bought at the cost of higher inflation.

The whole curve can shift. It shifts to the right if the inflation rate associated with any given unemployment rate increases — for example, if workers hold out for higher wages because they expect future inflation to be higher, or if workers become less skilled. Improvements on the supply side of the economy shift the curve to the left.

The expectations-augmented Phillips curve

The traditional Phillips curve is supported by Keynesians but is questioned by monetarists. Monetarists argue that, while there may be a short-run trade-off, in the long run policy tools that raise aggregate demand have no impact on unemployment and only succeed in raising the inflation rate. To support this view, the US economist Milton Friedman developed the expectations-augmented Phillips curve, drawn as a vertical line whose position is determined by the natural rate of unemployment (see Figure 46.6).

The story the diagram tells works like this. Suppose unemployment starts at 8% with low inflation. An increase in aggregate demand succeeds in pulling unemployment down to 4%, but it also pushes inflation up to 5%, moving the economy on to a higher short-run Phillips curve. Firms expand their output, and more people are drawn into the labour force by the higher wages on offer. Eventually firms realise that their own costs have risen in step, so their real profits are unchanged, and they cut output back. Some workers, recognising that real wages have not actually risen, leave the labour force. Unemployment returns to 8% in the long run, but 5% inflation has now been built into expectations: firms and workers assume inflation will continue at 5% when setting prices and wages. A second attempt to push unemployment down to 4% therefore moves the economy on to an even higher short-run Phillips curve, pushing inflation up to 12%, with the long-run unemployment rate still anchored at the natural rate.

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End-of-chapter practice

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