3.7. CONFLICT OF OBJECTIVES
In section 1, we look at the objectives of a government. There were four main objectives and these objectives were:
- Stable and sustainable economic growth
- Stable unemployment
- Stable price level (inflation)
- Stable balance of payments
In addition to these objectives, there are other objectives that governments pursue but these are the main 4. However, it can often be the case that there will be a conflict of objectives, whereby a policy may solve one policy but have an adverse effect on another policy. For example, the government may decide that the level of unemployment in the economy is too high and they wish to reduce the level of unemployment. They do this by increasing the level of government expenditure, which shifts AD out to the right, which results in more output (economic growth), lower unemployment (or more employment) and a rise in the price level. This policy by the government of increased public expenditure has decreased the level of unemployment (its aim) but it has had a cost of increasing the level of inflation in the economy; it has solved one problem but created another problem.
Another conflict would be when the government decides than an economy is overheating and decides to adopt policies that cause the exchange rate to appreciate (raise the base rate of interest). This increase in the exchange rate will make this economy’s exports relatively more expensive, which causes foreigners to purchase from other countries rather than this economy and therefore exports fall. Also, imports become relatively cheaper meaning that domestic residents will probably choose to buy foreign goods rather than domestic goods. Therefore, imports rise and exports fall, which causes the balance of payments to worsen. Along with the worsening of the balance of payments, economic growth will also fall but one could argue that it would fall to a more sustainable level. But the effect of taking demand out of the economy will result in the economy having a lower rate of inflation, which would be desirable as before when the economy was overheating inflation may have been above the government’s definition of “stable”. Therefore, this appreciation policy decreases the inflation (good), makes economic growth more sustainable (good), may cause a rise in unemployment (bad) and will worsen the balance of payments situation (bad). Thus, the policy is good for some objectives but bad for others.
Let’s suppose now that our economy has been hit by a supply side shock such as an increase in the price of oil. This supply side shock causes the SRAS to shift to the left, resulting in a negative output gap and a rise in the price level. This shock has decreased economic growth and raised the level of inflation. What should the government do? The government may choose to view inflation as the main priority and choose a policy to decrease inflation. A way to reduce inflation would be to take demand out of the economy and this can be done through contractionary fiscal or monetary policies. These policies would result in AD shifting to the left, which will cause real output to fall even further but inflation will decline. Therefore, this policy has solved the inflation problem but has resulted in lower economic growth and an increase in the unemployment rate. Therefore the government must decide whether they wish to have a low inflation rate with higher unemployment and lower growth or higher inflation with faster growth and a better level of unemployment.
These conflicts are hard to solve and the government must consider what the effect will be on the whole economy and on all the objectives that they are wishing to pursue. It will rarely be the case that the government can have all of these 4 objectives met at once. Also, it needs to be noted that the government will have other objectives in addition to these 4 objectives, such as decreasing inequality, increasing sustainability, improving working conditions etc.
Another conflict would be when the government decides than an economy is overheating and decides to adopt policies that cause the exchange rate to appreciate (raise the base rate of interest). This increase in the exchange rate will make this economy’s exports relatively more expensive, which causes foreigners to purchase from other countries rather than this economy and therefore exports fall. Also, imports become relatively cheaper meaning that domestic residents will probably choose to buy foreign goods rather than domestic goods. Therefore, imports rise and exports fall, which causes the balance of payments to worsen. Along with the worsening of the balance of payments, economic growth will also fall but one could argue that it would fall to a more sustainable level. But the effect of taking demand out of the economy will result in the economy having a lower rate of inflation, which would be desirable as before when the economy was overheating inflation may have been above the government’s definition of “stable”. Therefore, this appreciation policy decreases the inflation (good), makes economic growth more sustainable (good), may cause a rise in unemployment (bad) and will worsen the balance of payments situation (bad). Thus, the policy is good for some objectives but bad for others.
Let’s suppose now that our economy has been hit by a supply side shock such as an increase in the price of oil. This supply side shock causes the SRAS to shift to the left, resulting in a negative output gap and a rise in the price level. This shock has decreased economic growth and raised the level of inflation. What should the government do? The government may choose to view inflation as the main priority and choose a policy to decrease inflation. A way to reduce inflation would be to take demand out of the economy and this can be done through contractionary fiscal or monetary policies. These policies would result in AD shifting to the left, which will cause real output to fall even further but inflation will decline. Therefore, this policy has solved the inflation problem but has resulted in lower economic growth and an increase in the unemployment rate. Therefore the government must decide whether they wish to have a low inflation rate with higher unemployment and lower growth or higher inflation with faster growth and a better level of unemployment.
These conflicts are hard to solve and the government must consider what the effect will be on the whole economy and on all the objectives that they are wishing to pursue. It will rarely be the case that the government can have all of these 4 objectives met at once. Also, it needs to be noted that the government will have other objectives in addition to these 4 objectives, such as decreasing inequality, increasing sustainability, improving working conditions etc.