Macroeconomic objectives

• Distinguish short-term growth from long-term growth on a PPC and on AD/AS diagrams, and calculate a growth rate from data.
• Discuss what growth does to living standards, the environment and the distribution of income.
• Calculate an unemployment rate and explain why the official figure can mislead.
• Explain cyclical, structural, frictional and seasonal unemployment with the correct diagram for each, and define the natural rate.
• Explain the personal, social and economic costs of unemployment.
• Build a consumer price index from a basket of goods, calculate inflation from it, and explain the limits of the index.
• Explain demand-pull and cost-push inflation with diagrams, and the costs of high inflation.
• Distinguish disinflation from deflation, and explain the two causes of deflation and its costs.
• Evaluate the relative costs of unemployment and inflation and the four potential conflicts between objectives.

A macroeconomic objective is an outcome for the whole economy that a government tries to achieve through its policies. Three of them are economic growth, low unemployment, and a low and stable rate of inflation. Each has to be defined, measured and explained before the costs of missing it, and the conflicts between the objectives, can be judged.

Economic growth is an increase in real GDP over time. Real GDP is used because it removes the effect of price changes. Nominal GDP can rise when the economy produces no more than before, simply because prices are higher.

Growth is measured as the percentage change in real GDP from one period to the next: growth rate = (real GDP this year − real GDP last year) ÷ real GDP last year × 100. If the data are nominal, each year's figure is first converted to real GDP with the GDP deflator: real GDP = nominal GDP ÷ deflator × 100.

• A negative growth rate means that real output fell.
• A growth rate that falls but stays positive, for example from 4% to 2%, means that output is still rising, only more slowly.
• Living standards follow real GDP per person. If the population grows faster than real GDP, output per person falls even though the economy is growing.

Short-term growth, or actual growth, is a rise in the output the economy really produces, achieved by bringing unemployed resources into use. On a production possibilities curve (PPC) it is a movement from a point inside the curve to a point nearer to it or on it. The curve does not move, because the quantity and quality of resources have not changed: workers and machines that were idle are now producing.

In the AD/AS model, short-term growth comes from a rise in Aggregate demand (AD). Consumption, investment, government spending or net exports rise, so AD shifts to the right. Firms see their sales rise and their stocks fall, so they increase output and hire workers who were unemployed. Real GDP rises. On an upward-sloping SRAS curve the price level rises as well, because higher output raises firms' unit costs. This works only while there is spare capacity. Once real GDP reaches full employment output, further increases in AD raise the price level and not output.

Long-term growth is growth in production possibilities: an increase in Potential output, the output the economy can produce when its resources are fully employed (potential growth). On the PPC the whole curve shifts outward, so combinations that were unattainable become attainable. In the AD/AS model long-run aggregate supply (LRAS) shifts to the right, and full employment output rises from Yf1 to Yf2.

• More factors of production: a larger labour force (population growth, immigration, higher participation), more capital from investment, newly discovered natural resources.
• Better factors of production: education and training raise the skills of workers (human capital), and new capital embodies better technology.
• Better use of them: improved technology, more efficient organisation of production and more reliable institutions, such as secure property rights and a stable financial system, raise the output obtained from given resources.

The two kinds of growth depend on each other. Long-term growth sets the ceiling, and short-term growth decides how close actual output comes to it. A rise in AD with no rise in LRAS runs into the capacity limit and turns into inflation. A rise in LRAS with no rise in AD leaves the new capacity unused. Sustained growth without rising inflation needs AD and LRAS to increase together. Investment does both: it is a component of AD now, and it adds to the capital stock that determines LRAS later.

Growth is pursued because of what it makes possible, and it is questioned because of what it can cost. Three consequences are examined: the effect on living standards, on the environment and on the distribution of income. For each one the direction of the effect turns on identifiable conditions.

Living standards. Growth raises average real income, so households can consume more goods and services. A growing economy creates jobs, which lowers unemployment. Tax revenue rises without any increase in tax rates, because incomes, spending and profits are all higher, and the government can spend the extra revenue on health care, education and infrastructure. In low-income countries this is how growth reduces absolute poverty.

• The gain is real only if real GDP grows faster than the population, so that real GDP per person rises.
• An average hides the distribution. If most of the extra income goes to a small group, the typical household gains little.
• The composition of output matters. Growth in capital goods or military output does not raise current consumption, although investment raises consumption later.
• Growth can come with longer working hours, stress, congestion and pollution, none of which real GDP subtracts.

The environment. More production and consumption use more energy and raw materials and create more waste and emissions. These are negative externalities: costs that fall on third parties, including future generations, and that producers do not pay. Growth that depletes forests, fish stocks, soil or a stable climate is not sustainable, because it reduces the resources on which future output depends.

• Growth is more damaging when it is energy-intensive and the energy comes from fossil fuels, and when it is concentrated in heavy industry. Growth in services uses fewer materials for each unit of output.
• Growth is less damaging when external costs are priced or regulated (carbon taxes, tradable permits, emission standards), because firms then have an incentive to produce more cleanly.
• Higher incomes also pay for cleaner technology, and richer societies tend to demand stronger environmental protection. The extra tax revenue from growth can fund it.

Income distribution. Growth can widen or narrow inequality. It widens the gap when the gains go mainly to the owners of capital and to highly skilled workers: new technology raises the demand for their skills and reduces the demand for routine labour. It narrows the gap when it creates jobs for low-income and previously unemployed workers, and when the government uses the extra tax revenue for transfer payments, education and health care that benefit poorer households most.

• Labour-intensive growth, for example in manufacturing or construction, spreads income more widely than capital-intensive growth, for example in mining or finance.
• A progressive tax and benefit system passes part of the gains to lower-income households; without one, the market distribution stands.
• Regional concentration matters: growth centred on a few cities or industries leaves other regions behind.

A person is unemployed if they are of working age, without work, available for work and actively looking for it. All four conditions must hold. Students, people caring for family members, retired people and anyone else who is not looking for a job are outside the labour force; they are not unemployed.

The Labour force is the number of people employed plus the number unemployed. The Unemployment rate is the number of unemployed people as a percentage of the labour force: unemployment rate = number unemployed ÷ labour force × 100. The denominator is the labour force, not the whole population and not the working-age population. Statistical offices estimate the figures from a regular survey of households.

The official rate is a useful summary, but it is an imperfect measure of how much labour is going unused. The difficulties run in both directions.

• Hidden unemployment: discouraged workers want a job but have given up looking, so they are counted as outside the labour force. The official rate then understates joblessness, and it can even fall in a long recession as more people stop searching.
• Underemployment: people who work part-time but want full-time work, or who work in jobs below their skill level, are counted as employed. The rate does not show this wasted labour.
• The informal economy: people working without being recorded may be counted as unemployed, or may claim benefits while working. Here the official rate overstates unemployment.
• An average hides disparities. One national rate says nothing about differences by region, age, gender or ethnic group, or about how long people have been out of work. Long-term unemployment is far more damaging than a short spell between jobs.
• Definitions and survey methods differ between countries and change over time, so comparisons across countries and across years are approximate.

Unemployment has four types, each with its own cause. The type matters because the policy that reduces one kind does little for another.

Cyclical unemployment, also called demand-deficient unemployment, is caused by a fall in aggregate demand in the downturn of the business cycle. Households and firms spend less, so firms sell less and cut output. The demand for labour is derived from the demand for the goods that labour produces, so firms need fewer workers. If money wages fell quickly, firms could keep everyone employed at lower pay; in practice wages are slow to fall, because of contracts, minimum wage laws and the damage that pay cuts do to morale. Firms therefore lay workers off. Unemployment rises in most industries and regions at the same time, and it falls again when aggregate demand recovers.

Structural unemployment is caused by a lasting mismatch between the unemployed and the jobs available. The jobs exist, but the unemployed do not have the skills they need (occupational immobility) or do not live where the jobs are (geographical immobility). It arises when the structure of the economy changes.

• A permanent fall in the demand for one industry's product, because tastes change or lower-cost foreign producers take the market, reduces the demand for that industry's workers.
• New technology replaces a type of labour, as automation has replaced many routine manufacturing and clerical jobs.
• Labour-market rigidities keep the wage above the level that would clear the market: a minimum wage set above equilibrium, or employment protection laws and benefit rules that discourage hiring and job search.

Seasonal unemployment arises because the demand for some kinds of labour varies with the time of year. Workers in tourism, farming and construction are laid off in the off-season. It is predictable and short-lived, and published unemployment figures are usually seasonally adjusted to remove it.

Frictional unemployment is the unemployment of people who are between jobs or have just entered the labour force and are searching for a suitable post. It exists because finding and filling a vacancy takes time and information is imperfect. It is short-term, and some of it is useful: a worker who takes time to find a job that fits their skills is more productive than one who takes the first job offered. Better job information reduces it.

The Natural rate of unemployment is the sum of structural, frictional and seasonal unemployment. It is the unemployment that remains when the economy is producing at full employment output and cyclical unemployment is zero. Full employment therefore does not mean that everyone has a job. Actual unemployment = natural unemployment + cyclical unemployment: in a deflationary gap actual unemployment is above the natural rate, and in an inflationary gap it is temporarily below it.

The costs of unemployment fall on the unemployed themselves, on the society around them and on the economy as a whole.

Personal costs. An unemployed person loses most of their income, so their standard of living falls and they may run down savings or go into debt. The longer they are out of work, the more their skills and work habits erode and the less attractive they become to employers, which makes the next job harder to find. Unemployment is also associated with stress, poorer physical and mental health, and strain within families.

Social costs. Areas with high and lasting unemployment tend to have more poverty, more homelessness and more crime. Because unemployment is concentrated among particular groups and regions, it widens inequality and can cause social tension and a loss of trust in public institutions.

Economic costs. These are the costs to the economy and to the government's budget.

• Lost output: with labour unused, the economy produces inside its PPC, and real GDP is below potential output. The goods and services that the unemployed would have made are never produced.
• A weaker budget: unemployed people pay less income tax and spend less, so revenue from direct and indirect taxes falls, while spending on unemployment benefits rises. The opportunity cost is the other spending this money could have paid for.
• Lower consumption: the fall in the incomes of the unemployed reduces their spending, which cuts the sales of other firms and can lead to further job losses.
• Lower potential output in the future: if long-term unemployment destroys skills, the quality of the labour force falls, and with it the economy's productive capacity.

Inflation is a sustained increase in the average price level. Two words carry the definition. Sustained: a single jump in prices is not inflation unless prices go on rising. Average: some prices can fall while the general level rises. Inflation reduces the purchasing power of money, because each unit of currency buys fewer goods and services than before.

Inflation is measured with the consumer price index (CPI), which tracks the cost of a fixed basket of goods and services bought by a typical household. A survey of household spending decides which items go into the basket and how much of each. Prices of those items are then collected at regular intervals, and the cost of the whole basket is compared with its cost in a base year.

1. Cost of the basket in a year = the sum of (price in that year × quantity in the basket) for every item. The quantities stay the same in every year; only the prices change.
2. CPI = cost of the basket in the year ÷ cost of the basket in the base year × 100. The index is 100 in the base year.
3. Inflation rate = (CPI this year − CPI last year) ÷ CPI last year × 100.

The quantities act as weights. An item that households buy in large amounts, or that takes a large share of their spending, moves the index more than one they rarely buy: a 10% rise in rents raises the cost of the basket by far more than a 10% rise in the price of salt.

The CPI is the standard measure, but it does not measure the change in every household's cost of living, and it is not perfectly accurate even for the average household.

• It describes a typical household. Households with different spending patterns face different inflation rates: a pensioner who spends a large share of income on heating and food is hit harder by a rise in energy prices than the index suggests.
• Substitution bias: the basket is fixed, but consumers switch away from goods whose prices rise most towards cheaper substitutes. The fixed basket therefore overstates the rise in what they actually pay.
• Changes in quality: a higher price may reflect a better product. If a phone costs 10% more but is much more capable, counting the whole 10% as inflation overstates it.
• New products enter the basket only when it is revised, so the index is slow to reflect what households now buy.
• Countries build their indices differently, for example in how they treat the housing costs of owner-occupiers, which weakens international comparisons.
• Food and energy prices are volatile and can move the index sharply for a few months. Central banks therefore also watch a core measure of inflation that leaves them out.

Demand-pull inflation is caused by increases in aggregate demand. Higher consumer or business confidence, lower interest rates, higher government spending, lower taxes or stronger export demand raise one or more components of AD, so AD shifts to the right. When the economy is at or near full employment output, firms have little spare capacity: to produce more they must pay overtime and compete for scarce workers and materials, so unit costs rise and they raise prices. The extra spending pulls the price level up. Real GDP rises in the short run and unemployment falls, so demand-pull inflation is the inflation of a boom.

Cost-push inflation is caused by increases in the costs of production across the economy. Money wages rising faster than productivity, dearer raw materials or energy, dearer imports after the currency depreciates, and higher indirect taxes all raise firms' unit costs. At each price level production is less profitable, so firms supply less: SRAS shifts to the left. The price level rises while real GDP falls, so unemployment rises. Rising prices together with falling output and rising unemployment is called Stagflation.

The cause matters for policy. Demand-pull inflation can be reduced by contractionary fiscal or monetary policy: AD shifts back to the left, and the cost is some loss of output from a level the economy could not sustain anyway. Against cost-push inflation the same policy lowers the price level only by pushing real GDP down further, when output has already fallen. Policymakers then face a choice between accepting the inflation and accepting higher unemployment.

Inflation can persist after its first cause has passed. If workers expect prices to keep rising they ask for higher money wages to protect their real incomes. Firms that grant them face higher costs and raise prices, which confirms the expectation and leads to the next round of wage claims. This wage–price spiral is why central banks try to keep expected inflation low and stable.

A high rate of inflation is costly for six reasons. Each is a mechanism, not just a label.

• Uncertainty. When inflation is high it is also hard to predict. Firms cannot forecast their future costs, prices or the real return on an investment, so they postpone investment. Households are unsure of their future real incomes. Lower investment reduces both AD now and productive capacity later.
• Redistributive effects. Inflation moves purchasing power between groups without anyone deciding that it should. People on fixed incomes, and workers whose pay rises more slowly than prices, lose real income. Savers and lenders lose when the nominal interest rate is below the inflation rate, because the money they get back buys less. Borrowers gain, because the real value of what they owe falls, and so do owners of property and other real assets. Lower-income households usually lose most: more of their income is in fixed benefits or weakly bargained wages, and they hold fewer real assets.
• Effects on saving. If the nominal interest rate is below the inflation rate, the Real interest rate is negative and savings in the bank lose value. Households save less, or move their savings into property, gold or foreign currency. Fewer funds are then available to lend to firms for investment.
• Damage to export competitiveness. If prices rise faster than in trading partners, exports become dearer abroad and imports relatively cheaper at home. Export volumes fall and import volumes rise, so net exports and AD fall and jobs are lost in exporting and import-competing industries. A depreciation of the currency can offset this, but it raises import prices and so adds to inflation.
• Impact on economic growth. Lower investment, lower saving and lower net exports all reduce growth. In addition, the central bank will sooner or later raise interest rates to bring inflation down, which reduces consumption and investment further.
• Inefficient resource allocation. When all prices are rising it is hard to tell whether the price of one good is rising relative to others, so prices signal scarcity less clearly and resources are drawn to the wrong uses. Firms spend resources changing prices, and funds flow into speculation in assets that are expected to keep their value and away from productive investment.

Disinflation is a fall in the rate of inflation. The rate stays positive, so prices are still rising, only more slowly: inflation falling from 6% to 2% is disinflation. Deflation is a sustained fall in the average price level, so the inflation rate is negative. The two are different. Disinflation is usually what a central bank wants when inflation is above its target; deflation is something it tries to prevent.

Deflation has two possible causes, and they have opposite effects on output. A fall in aggregate demand, for example after a financial crisis, a collapse in confidence or a fall in export demand, shifts AD to the left. Firms cannot sell their output at existing prices, so they cut both prices and production. The price level falls, real GDP falls and cyclical unemployment rises. This is the harmful kind, sometimes called bad deflation.

An increase in short-run aggregate supply can also lower the price level. If production costs fall across the economy, because energy or raw materials become cheaper or productivity rises, SRAS shifts to the right. The price level falls while real GDP rises and unemployment falls. Deflation of this kind is benign, because output and real incomes are growing. Whenever falling prices are discussed, the first step is to say which curve has moved.

The costs of deflation are greatest when it is caused by falling demand. There are seven.

• Uncertainty. Firms cannot predict the prices they will receive, so the expected return on investment is unclear and they invest less.
• Redistributive effects. These are the reverse of inflation's. Lenders and savers gain, because the money repaid to them buys more. Borrowers lose. People on incomes fixed in money terms gain purchasing power, as long as they keep their jobs.
• Deferred consumption. If households expect prices to be lower next year they postpone purchases, above all of durable goods such as cars and furniture. Consumption falls, AD shifts further left and prices fall again: a deflationary spiral.
• Cyclical unemployment and bankruptcies. Firms' revenues fall with prices, but wages and debt repayments are fixed in money terms. Profits are squeezed, so firms lay off workers and some go bankrupt.
• A rise in the real value of debt. Debts are fixed in money terms while prices and money incomes fall, so the real burden of repayment rises. Indebted households and firms cut their spending to keep up repayments, or default. Banks then make losses and lend less, which lowers AD again.
• Inefficient resource allocation. Falling prices and falling expected returns discourage investment in new capacity, so resources stand idle and are not moved to more productive uses.
• Policy ineffectiveness. A central bank cannot cut its nominal interest rate far below zero. With prices falling, the Real interest rate (the nominal rate minus the inflation rate) is positive even when the nominal rate is zero, and it rises as deflation deepens. Households and firms with low confidence do not borrow, so monetary policy loses much of its power to raise AD.

Deflation caused by falling demand is treated as more dangerous than moderate inflation for two reasons. Deferred consumption, bankruptcies and the rising real value of debt reinforce one another, so a fall in prices can feed on itself. And policy ineffectiveness weakens the main tool for stopping it.

Governments often cannot reduce unemployment and inflation at the same moment, so they have to decide which problem is the more costly. Neither is always worse. The comparison turns on how high each one is, what is causing it and how long it lasts.

The case that unemployment is the more costly rests on three points. Its burden is concentrated: a minority of households lose most of their income, while everyone else is barely affected. The output that unemployed workers would have produced is lost for good, since idle labour cannot be stored and used later. And long spells out of work damage skills and health, so high unemployment today can lower employment and potential output for years afterwards.

The case that inflation is the more costly also rests on three points. Its burden is widespread: every household and firm faces rising prices, and those on fixed incomes and with savings lose most. When it is high and unstable it reduces investment, saving and export competitiveness, which in time costs growth and jobs as well. And once people expect high inflation it becomes built into wage claims and price setting, so bringing it down requires a period of low demand and higher unemployment. Tolerating inflation therefore postpones an unemployment cost and does not avoid it.

• The levels. Inflation of 3% with unemployment of 10% is an unemployment problem; inflation of 15% with unemployment of 4% is an inflation problem. The costs of each rise more than in proportion as it rises.
• The type of unemployment. Cyclical unemployment can be reduced fairly quickly by raising aggregate demand, so leaving it in place is a cost that could be avoided. Structural unemployment does not respond to demand, so accepting more inflation to reduce it achieves nothing.
• Expectations of inflation. While they are low and stable, a temporary rise in prices passes without lasting damage. Once they start to rise, delay raises the eventual cost of restoring price stability.
• The welfare system. Generous unemployment benefits and retraining reduce the personal and social costs of unemployment; pensions and benefits linked to prices reduce the redistributive cost of inflation.
• The time horizon. In the short run lower unemployment can be bought with higher demand and some inflation. In the long run, in the monetarist/new classical view, output returns to its full employment level whatever the price level, so higher inflation buys no lasting fall in unemployment.

A conflict between objectives exists when a policy that moves the economy towards one objective moves it away from another. Four potential conflicts are examined. Each arises through a specific mechanism and only under certain conditions; none is automatic.

Low unemployment and low inflation. Expansionary fiscal or monetary policy shifts AD to the right. Real GDP rises, firms hire more workers and cyclical unemployment falls. As output approaches full employment output, spare capacity runs out and firms raise prices, so the lower unemployment comes with demand-pull inflation. In the other direction, contractionary policy shifts AD to the left: inflation falls, but real GDP falls and cyclical unemployment rises.

• The conflict is sharp when the economy is close to full employment output, where extra demand mostly raises prices.
• It is weak or absent when there is plenty of spare capacity. On the horizontal section of a Keynesian AS curve, AD can rise and unemployment can fall with no rise in the price level.
• It is avoided when unemployment is reduced from the supply side. Training, better job information and investment shift LRAS to the right, which lowers structural and frictional unemployment and puts downward pressure on the price level.
• Cost-push inflation makes both worse at once: a leftward shift of SRAS raises the price level and unemployment together, so there is no favourable choice to be made.

High economic growth and low inflation. Growth that comes from aggregate demand rising faster than productive capacity pulls the price level up, because output runs into the limit set by LRAS. Growth that comes from rising productive capacity does not: when LRAS shifts to the right, real GDP can rise with a stable or falling price level. The conflict therefore bites when growth is demand-led and the economy is near capacity, and it eases when investment, education and technology raise potential output in step with demand.

High economic growth and environmental sustainability. Sustainability means meeting present needs without reducing the ability of future generations to meet theirs. Higher output uses more energy and raw materials and creates more waste and emissions, so rapid growth can deplete common resources and add to climate change, lowering the well-being and the productive capacity of future generations. The conflict bites when growth depends on fossil fuels and resource extraction and the external costs are unpriced. It eases when pollution is taxed or regulated, when growth comes from services and cleaner technology, and when part of the income from growth is spent on protecting the environment.

High economic growth and equity in income distribution. Equity means fairness in the distribution of income. Growth can make the distribution less equal when its gains go mainly to owners of capital and to highly skilled workers, and when policies used to promote growth, such as lower taxes on profits and high incomes or less generous benefits, favour those who are already better off. The conflict bites when growth is capital-intensive and concentrated in a few sectors or regions and when the tax and benefit system redistributes little. It eases when growth creates jobs for low-income workers and when the extra tax revenue is spent on education, health care and transfer payments.

The points below are the ones most often lost in examination answers on the macroeconomic objectives.

• Growth. Actual (short-term) growth uses spare capacity: a movement from inside the PPC towards it, shown on an AD/AS diagram by a rightward shift of AD that raises real GDP towards potential output. Growth in production possibilities is an outward shift of the PPC and a rightward shift of LRAS. Do not shift LRAS because spending rose.
• Growth rate. Use real GDP, and divide the change by the earlier year. A lower but positive growth rate means output is still rising.
• Unemployment rate. Divide by the labour force (employed plus unemployed), never by the population. People who are not looking for work are not unemployed.
• Types of unemployment. Cyclical unemployment is shown by a deflationary gap on an AD/AS diagram; structural unemployment is shown on a labour-market diagram with Wage rate on the vertical axis. Full employment means unemployment at the natural rate, not zero.
• Inflation rate. It is the percentage change in the CPI, not the change in index points and not the index itself.
• Causes of inflation. Demand-pull: AD shifts right, and real GDP rises. Cost-push: SRAS shifts left, and real GDP falls.
• Disinflation and deflation. Disinflation is a lower but positive rate of inflation. Deflation is a falling price level. Say which curve caused the deflation before judging its costs.
• Conflicts. No conflict between objectives is automatic. Each answer needs the condition under which it bites (near full employment output, demand-led growth, unpriced pollution, little redistribution).